Option Investor
Market Wrap

Rate Hike Recession

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WE 04-15


WE 04-07

WE 04-01



- 381.00


+ 57.04


- 38.57



-   91.20


+ 14.54


-   6.25

S&P 100


-  14.93


+   4.69


-   0.22

S&P 500


-  38.58


+   8.28


+  1.50



- 387.81


+ 65.86


+  7.05





+   5.73


-    4.66



-  29.97


-    0.80


-    3.71



- 216.92


-  89.91


-  58.06














Rate Hike Recession

The Fed has a habit of raising rates until they create a recession and indicators from multiple sources suggest they have hit that target already. Economic indicators are turning down in rapid succession and stocks are following in hot pursuit. Conflicting earnings and falling sentiment sent traders heading for the exit in droves and the Dow posted the worst three-day drop since Jan-2003.

Dow Chart - Daily

Nasdaq Chart - Daily

Friday's economics turned decidedly worse with the NY Empire State Manufacturing Survey falling to only 3.1 and far below consensus estimates of 19.0 and the 20.2 posted in March. It was an ugly number and one that echoed the economic sentiment being felt among traders. This was the lowest number recorded in over two years. It is a dramatic sign of a slowdown in the New York area and mirrors some other reports showing sharp drops in activity over the last month. New orders fell into negative territory at -0.2, back orders -8.3, inventories -1.6 and the average workweek dropped to -4.4. All indicators of a drop in activity and a forecast that employment could fall sharply soon. Only 27% of the respondents reported an increase in orders. This was down from 38% in March. Another 27% of respondents reported a decline in orders for the period. Prices paid rose sharply to 53.2 from 48.8 in March and suggests inflation is rising through the product chain. Overall the six-month outlook fell from 44.5 to 36.8 and gives us a clue as to what manufacturers expect for the summer. The recent cycle high of 62.1 was posted in Sept-2004.

Consumer Sentiment fell to 88.7 in April from 92.6 in March. This was the fourth consecutive monthly decline from December's cycle high of 97.1 and April was the largest decline for those four months. The expectations component fell to 79.0 from 82.8 and the present conditions component fell to 103.9 from 108.0. Expectations are dropping faster than the current conditions component and suggests consumers are becoming increasingly worried about the future. The price of gasoline and rising heating bills are weighing on consumers as they try to stretch their dwindling dollars as far as possible. Friday's number was the lowest level of sentiment since September-2003. The Consumer Sentiment and Confidence numbers directly relate to how much money consumers are expected to spend over the next six months. Those consumer numbers are also felt in corporate boardrooms as they plan their investment depending on how they feel the economy will do over the coming year. It is a line of dominoes and once that line begins to fall it can have long term consequences.

Industrial Production rose slightly at +0.3% and only +0.1% over last months level. The majority of the gains came from oil wells and mining. The higher oil prices stimulated reactivation of marginal wells and that offset a decline in manufacturing output. There were also some indications that employment may be slipping as manufacturers start taking early measures to avoid over employment during an approaching slump. Higher productivity comes from more output per worker and fewer workers skew that number higher.

The drops in economic news was not as damaging to the market as the IBM earnings comments. IBM surprised investors by releasing earnings two days earlier than expected and it was a nasty surprise. IBM missed earnings estimates by a nickel and revenue fell well below analyst's estimates. IBM said the quarter started strong but weakened significantly as the quarter progressed. They claimed it was tough to close transactions in the final weeks, especially in countries with soft economics. IBM singled out Japan, Germany, Italy and France as very soft economies and on the verge of a recession. IBM said revenue rose +7% in January falling to +5% in February and then dropping to a decline of -0.1% in March. This dramatic drop in sales for a company as large and diverse as IBM sent shockwaves through the tech sector. They also said they would be embarking on a sizeable restructuring program over the next three months to combat the soft patch they are seeing. The IBM earnings miss and economic warning was even worse since they released the news unexpectedly two days early and just before option expiration. I am sure thousands of option holders were cruising calmly into expiration only to be blindsided by the news. Of course those holding puts were extremely pleased with their windfall from the -$7 drop. IBM's drop was responsible for a full 25% of the -191 Dow drop on Friday.

IBM Chart - Weekly

Helping confirm the news from IBM was news from a couple of high profile brokers. SG Cowen said spot checks at several locations showed an abrupt slowing of tech orders over the last 2-3 weeks. They said it was not only IBM but the slowing was widespread. JP Morgan also released a note that said corporate IT spending had slowed over the last several weeks AND it appeared it would continue through Q2. IBM was not the only tech to miss earnings. SUNW announced on Thursday and earnings missed estimates by -2 cents and elected not to provide estimates for the current quarter. Executives did say cost cutting efforts were on track. That is not what investors want to hear. CEO Scott McNealy tried to remain upbeat and expressed hopes they could return to breakeven soon. Gosh, that would be exciting. (grin) After a loss for the same period last year of -23 cents I bet he would be happy getting back to even but it is difficult to calculate a PE when there is no "E".

On the flip side GE reported a +25% rise in profits to 38 cents per share and beat the street by a penny. GE raised full year estimates slightly to $1.78-$1.83 from their prior $1.76-$1.83. I know that minor distinction is lost on most of us but the key point is they did not lower it. Nine of GE's divisions grew by more than 10% in the quarter. Profits were also helped by the sale of Genworth stock in a secondary offering. GE said it was positive about the future but that view was not shared by everyone. S&P reiterated a "hold" on GE stock and told investors not to add to positions at this level. S&P said GE was unlikely to sustain double-digit earnings growth despite Immelt's assurance to the contrary. GE has been trading flat for nearly four months and at the high end of its range. Dead money or a safe port in the storm? Over the 200-day average at $35 it would be a safe port given their announced buyback of $15 billion in shares. Under $35 it would tell us that investors are losing confidence in GE and its forecasts.

In plain English Friday's market was ugly. It was the largest one-day drop on the Dow since March 2003 and the largest three-day drop since January 2003. Volume was huge at 5.56B shares across all markets. It was nearly one billion more than Thursday's volume of 4.7B, which was the strongest volume day since Feb-28th. This sudden surge in volume, mostly down volume, looks very bad. On both days up volume was only 800 million shares. That was 4.5:1 in favor of declining volume on Thursday and 6:1 on Friday. Wednesday was 4:1 in favor of decliners. This is a monster change from our prior lackluster trend. There were numerous reasons for the investor flight including those I mentioned above. Primarily it was blamed on the consumer with a warning from Harley Davidson and slowing sales at Wal-Mart. Energy prices are finally filtering through sales and earnings as consumers retreat to the safety of the family TV rather than wandering the malls. Comcast said there has been a surge of usage in their on-demand movie services. This is causing problems not only for Blockbuster and Hollywood Entertainment but discretionary spending in general. As much as consumer weakness is impacting the economy I don't believe it was a material reason for this weeks weakness.

I believe there were multiple reasons for the drop this week. Many I have been repeating twice a week for a month. However, I believe the current three-day drop was nearly entirely tax related. We had a weak market for the prior three weeks but the charts changed significantly this week. Remember last Friday? We saw a strong bout of selling begin at resistance after the four-day rebound from the 10360 lows on the Dow. That selling was just like what we saw this week, slow but steady volume and mostly to the downside. This was attributed at the time to the coming FOMC minutes. When they were released and the initial press reports saw a calmer Fed with no urgency to the rate hike cycle we saw a huge short covering spike back to 10529. I said at the time it would probably not hold and the drop came as expected but not in the manner expected. Doing some chart forensics the Dow held at those levels until exactly 1:PM on Wednesday. When the clock struck 1:00 a monster sell program hit and the selling never relented for the next two days and accelerated into the close on Friday. Before 1:PM trading was listless with volume evenly split between advancers and decliners.

Dow Chart - 30 min

The key point here is the dramatic change in market internals at exactly 1:PM on Wednesday. I believe a large hedge fund, maybe several large funds or institutions needed to raise cash for tax payments. Everyone had waited for the last three weeks hoping the earnings cycle would generate some excitement and they could recover some of the March losses before selling to pay the taxman. When the calendar began to expire AND with the sudden appearance of negative economics and negative tech guidance, they pulled the exit trigger. While this may have only been a few large hedge funds they significantly impacted the herd sentiment in a negative way. Once the herd turns it tends it tends to stampede with the majority of traders unsure of why.

I heard over and over on Friday comments about "Black Monday" and the potential for a reoccurrence. I would discount any of those comments as emotional and reflecting the sudden switch to extreme pessimism. I don't see the same factors in play as Black Monday but I would not rule out any further selling. The markets always over react in both directions but most notably to the downside. While the hedge funds may have only started the ball rolling they did succeed in changing the balance of power in favor of the shorts. Sell stops were hit, dip buyers were steamrolled over and over and the survivors headed to the safety of the sidelines OR switched sides to trade the trend.

Why was this downdraft so strong? Because the upside rally was so long. Remember, hedge funds have made billions in energy stocks and commodities over the last year. Regular mutual funds have made a killing as well. Literally billions upon billions in profits have been generated. For those who believe as we do that $50 oil is an entry point those same funds were faced with a conundrum. Sell energy or sell stocks? The answer was evidently sell stocks. With the upside for stocks questionable at best in light of the Fed hike cycle there was no future for a long-term hold of stocks over the summer. On the energy side there is a strong possibility we will see another ramp into the fall with oil hitting new highs once again. This was an obvious choice for me. If you have to raise cash you sell the investments with the lowest potential for future returns. Complicating the tax problem was a significant shortfall in cash inflows to funds over the last quarter. AMG Data said stock funds only had inflows for the quarter of $55.8B compared to $88.7B for Q1-2004. For funds counting on last minute retirement contributions to make distributions it was a meager allowance. Funds see large cash flows around tax season as some investors make retirement deposits while other investors withdraw funds to pay taxes. The -37% drop in inflows from last year means funds had to sell stock to make the distributions.

The Dow came to rest at 10080 for a -450 point drop from Wednesday's highs. The Dow transports fell to 3379 for a -7.5% drop from the week's highs. All the major indexes broke their 200-day averages but the combination of the Dow and Dow Transports failing at the same time produces a strong Dow theory sell signal. It does not get much worse than this. Long-term uptrend support was broken and the Dow dropped into free fall below 10375 that could easily take it back to 9800.

The Nasdaq cracked uptrend support dating back to October-2002 and left the critical 200-day average well behind at 1991. The average had provided support for three weeks but once broken becomes a major sell signal for tech funds. The Nasdaq retreated to 1908 at the close and just above decent support at 1900. I have mentioned this number several times as a potential target over the last several weeks.

The S&P may not have cracked as badly as the Dow and Nasdaq but it did fail and in spectacular fashion. What should have been decent support at 1160 was barely a blink as the index plummeted to earth. Like the other indexes the two-year uptrend support failed as well as the 200-day at 1153. Unfortunately the S&P has farther to fall if it is to catch up to the Dow and Nasdaq. The equivalent level would be support at 1100.

S&P Chart - Daily

Crude Oil Chart - Daily

The key for next week is not what happened last week. If the selling was stimulated by tax payments then the selling surge should be over. However, regardless of the reasons that pushed the averages over the cliff we did go over the cliff and like in the Wylie Coyote cartoons it could be a long way to the bottom. Also, like in the cartoons there is normally a rock, anvil or some suitably heavy object always following him down to add additional pain. The severity of our drop, although likely program related, should trigger additional reactive selling on Monday. The potential for dip buyers to rush back into the market is somewhat subdued given the close proximity to 10000/1900. Those levels have likely become targets for buyers and the best scenario would be for a touch sometime Monday morning. That would clear the rest of the margin calls, sell stops and weak holders and give buyers a little more confidence. Bear in mind that the weekend newspapers are going to be filled with stories on how bad the markets are this week and why. This could produce some more reactive selling. Everyone wants to avoid a repeat of the summer of 2004, or worse.

If you look at the oil chart you will see that oil stopped its decline on Wednesday at $50 and a support level I mentioned several times over the last couple weeks. Despite the drop in the equity markets the price of oil remained stable. This confirms my theory that funds were not willing to dump oil at a significant entry level and elected to dump other stocks instead. The 100-day average is currently just over $49 and that is giving additional support to the psychological $50 level. Will it go lower? Yes, no, maybe and who the heck knows. We are only barely into the Q2 demand slump and oil inventories have increased for the last seven weeks. We have all the makings for a continued dip but the lack of a fade over the last three days suggests the speculators are still buying the dips. You can put me in that column as well as I will be entering several oil positions in the Leaps section this weekend. In past commentaries I have suggested entering positions at $50 and adding to those positions should we dip below $50. The most bullish period for oil is the late summer and fall and everyone needs to be positioned well ahead of that strong demand cycle.

For equities in general I would still avoid long positions for other than a trading bounce. We are grossly oversold and unless real underlying sentiment has changed drastically we should get a tradable bounce next week. Personally I would use any bounce as a short entry but realize a bounce could last several days. Old habits die hard and dip buyers learn slowly. The Fed may use any visits to the podium next week to allay fears that they are going to push the economy to its knees. However, I believe that historically 76% of Fed rate hike cycles eventually produce a recession. I have heard numbers over 80% but I think the 76% quote is more realistic. Either percentage does not paint a pleasant picture for our future. Once the Fed embarks on a rate hike cycle it is like stopping a bulldozer. They tend to just keep plodding forward regardless of the economic surroundings until they reach their desired rate level, which in this case appears to be about 3.5% and three hikes away. That sets up the August meeting as the pivot point for a change in Fed action. Coincidentally it is also just before the typical Sept/Oct crash that makes such a good entry point for year-end trades. I believe that the coming summer doldrums will be just that, doldrums. The markets will be range bound and lifeless until fall as they wait to see if the economy recovers from the current soft patch, the Fed moves to the sidelines and where oil is headed in the next up cycle. This is not a good environment for buy and hold investing. It is a great environment for option traders and we will try to quickly determine the range once it is set and profit from the swings.

I have been warning about the impending market decline for several weeks and anyone following my advice would have been flat/short before this weeks decline began. I discussed in these pages that the rebound in early April was likely to fail at resistance and that the short covering spike from the Fed minutes would likely fail as well. I have been warning everyone not to be long for several weeks. I received numerous emails trying to convince me that my viewpoint was wrong. Didn't I know that companies were going to report great earnings and the market was going to new highs? Didn't I realize that the economy was in a stealth rally? Everyone should have their own market view and opinion. This is what makes a market and allows us to generate profits when we are right. The only point I would make is that traders should not be married to their bias or their positions. Do your research, read our commentary and form your own opinions. Just don't keep throwing money at those opinions if they turn out to be wrong. The market can move opposite your bias longer than you can stay solvent. Don't be afraid to switch sides when trades don't go as planned. Anyone following my advice over the last month should have paid for his or her subscription many times over. Now, take that extra money and buy some energy stocks!

SOX Chart - Daily

For next week I would look for a rally attempt and one that could last several days. However, since IBM stunk up the earnings parade so successfully the urge to buy may turn into excessive caution ahead of the heaviest earnings calendar for the current cycle. Do you think investors really want to be caught holding MMM, INTC or any other high profile stocks as they announce? I would bet the urge to gamble on an upside surprise has faded. Remember last Tuesday when I highlighted the chip stocks scheduled to announce as the key to tech direction? With several misses and poor guidance the SOX was already headed south at a high rate of speed by Thursday's close and IBM gave it a huge push. The SOX closed at 382 on Friday and well below the 410 and 400 support levels we had been watching. At 382 it is retesting the January lows and only slightly above lows for the last two years. Should Intel trip on Tuesday we could blow past those lows in a heartbeat. We also have the book-to-bill on Tuesday night so it could be a 1-2 punch for a knockout OR a first and second stage rocket higher if both are positive. Either way chips should go directional on Wednesday and that will be the spark or anchor that determines market direction for techs.

I have run out of space today but I feel like I could ramble for five or six more pages. This is a very critical point in the markets BUT it is not the end of the world regardless of what you hear on TV. Be patient and only take entries that you love and at prices you will be comfortable with even if you did not catch the turning point. There is always another trade as long as you protect your capital. This is not a time to be shooting from the hip but time to be a sniper instead. Pick your targets carefully and well in advance. Plan your trades and execute your plan and most of all enter passively and exit aggressively.


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