Despite several days of gains the conviction of buyers was tested as rumors of another Long Term Capital type of hedge fund failure filtered through the markets. Impact to hedge funds from the GM events of last week became the subject of much speculation as large trades were seen being unwound in global markets. Regardless of any truth behind the rumors it was simply a case of a lack of conviction that contributed to the drop.
Dow Chart - Daily
Nasdaq Chart - Daily
The rumor making the rounds suggested that a major hedge fund, GLG, was in serious trouble on a GM trade. There were many funds in the arbitrage trade in question, which was to be long the GM bonds and short the stock. The theory being that one side would offset a move in the other. The Kirk Kerkorian news last week spiked the stock +$5 and that spike has held. The following day S&P slashed the debt rating for GM. With GM soaring and its bonds collapsing those in the arbitrage trade were getting killed on both sides. Some of these positions were very large and fears of another Long Term Capital meltdown caused traders to run for cover. With Cisco earnings on tap as the after hours earnings headliner there was additional risk for techs.
Bonds soared on a flight to quality on fears of the unknown. While GLG was the name most mentioned in the rumor the real fear is that there could be a domino effect where the unwinding of large positions could move prices far enough to cause other funds to blow up as well. When large positions need to be unwound in a hurry it requires somebody to take the other side of the trade. Once the smell of blood starts to creep into the market the players who would normally be buyers tend to move to the sidelines until the smoke clears. This removes liquidity from the market and intensifies the problem. Funds then have to broaden their asset sale to raise cash to cover shortfalls. This could have been another factor in today's drop as equities were sold to raise cash. When rumors surface about hedge fund liquidity those high net worth investors are not bashful about withdrawing their cash. Memories of LTCM are vivid and nobody wants to be the last investor left holding the bag.
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With 8000 hedge funds holding over $1 trillion in assets there is plenty of risk if more than a few firms find themselves on the wrong side of the same trade. Many if not most are highly leveraged, which increases the risk. You may remember that LTCM was leveraged 100:1. This means for every $1 of assets they had $100 in risk. Much of that risk comes from borrowed money. Few if any firms are leveraged to that extreme today after several rounds of rule tightening but there is still extreme risk to the derivates market. Financials dropped on Tuesday as fears mounted that the majors could be exposed to credit risks from large funds in trouble. Deutsche Bank (DB) fell -2.67 on news that they were a lender to a large hedge fund in serious trouble. GS, BSC and LEH were also hammered on these worries.
I personally believe the market drop was simply a lack of conviction by last week's buyers. These fair weather buyers abandoned ship at the first sign of trouble. We have repeatedly seen weak advances on low volume with resistance holding firm for the last four sessions. Monday's advance was on the highest up volume we have seen in a week but the total volume was barely 3.5B shares. Today's numbers were 4:1 declining over advancing with volume of 3.8B shares. Still light but very lopsided in favor of decliners.
The techs may have declined on rumors but with Cisco earnings after the close there may have been a little added concern. Cisco did announce earnings that beat the street with a slight beat in revenue as well but there was little excitement. Cisco guided analysts to an increase of +9% to +11% sales for the current quarter. This was slightly over analyst estimates but far from that needed to produce a buying frenzy.
Dreamworks Animation (DWA) was knocked for a loss around 1:30 when news broke that employees had been told of a coming earnings miss. The stock fell -2 to $36.50 (-5%) on the news but that was just the start of a serious problem. After the bell DWA reported earnings of 44 cents when analysts were expecting 58 cents. When DWA reopened for trading after earnings it dropped another -7 to close at $29.70 and well off the day's high at $38.79. Disappointing sales of the Shrek 2 DVD was blamed with a large number of returns from retailers.
The transports were knocked for a loss after Delta filed a 10K saying they would not have enough cash to make it through 2005 without major concessions from their debt holders. They projected a continuing substantial loss and blamed a lot of their troubles on oil prices. Delta was forced to sell their fuel hedges in an earlier crisis to raise cash and are currently unhedged against high oil prices. They said for every penny per gallon of price increase in jet fuel they would lose an additional $25 million dollars. With oil climbing to a high of $53.15 today before retreating a buck into the close the odds of lots more red ink at Delta are very good.
Crude Oil Chart - Daily
Ten-Year Note Index - 2 min
The OPEC Secretary General was on CNBC today repeating the OPEC party line that there was plenty of oil in the system. He said OPEC produced about 30 million bpd in April and currently have 8.8% of spare production capacity. He said spare capacity in Q2 should rise to 9.1% and 10.9% in Q3. He said OPEC had projected demand to grow +1.89 mbpd in 2005. He also pointed out that OPEC countries were going to invest more than $100 billion over the next five years to increase production by 4-5 million bpd. You might wonder why they are on such a crash program if they already have so much spare capacity? The answer is clear and twofold. Truth is a rare commodity in OPEC where lying has become an art form to justify production allocations and increase the perceived status of each country. Secondly, as I continue to point out in my articles, much of the oil they produce is not the grade of oil the world needs. You could have 50% spare capacity in sour crude and not be able to give it away. The world relies mostly on the light sweet crude for its fuel needs and this is the commodity in short supply. When listening to any OPEC spokesman it is easy for them to confuse the issue because the reporters don't know what questions to ask. So far the 100-day average at $50 has held as support but inventories are continuing to build. Until gasoline consumption ramps up next month we could continue to see inventories increase. That means we may still have a retest of that $50 level in our future but any dip under $50 is still a buying opportunity.
Commodity stocks fell hard after several downgrades hit the steel sector. Falling sales prices and higher raw material prices are seen to be pressuring profits. More importantly it appears that demand is slowing. If that is the case then it could suggest the global economy is slowing and that raises a lot of other issues. The American Iron and Steel Institute said steel production had dropped -10% since April 2004. German giant ThyssenKrupp announced a -10% production cut for Q2 in an effort to counter a downward price trend. Mittal Steel Co. the world's biggest manufacturer, said consumption in the United States was suffering from "an inventory overhang." US Steel dropped -2.94, NUE fell -2.63, STLD fell -1.50 and is only a couple ticks from a new 52-week low. Ironically STLD and NUE officers made very positive comments about the industry and their outlook just this morning.
Internet stocks have suffered several setbacks this week. JOBS, the China employment site dropped to $13.80 this week from Friday's close at 20.44. They reported only a minimal rise in earnings and much higher expenses. PCLN fell -10% to $23.50 after posting earnings that disappointed. TOO broke support at the 200-day average and fell to a new five month low at $22 on no news. EBAY slipped back under $33 and its weeklong bounce appears in danger of being erased. YHOO fell back to support at $34 and appears ready to violate its recent uptrend. However, YHOO claims they have an Apple killer in the works and will announce its new music download service on Wednesday. They will charge $6.95 per month for unlimited downloads of more than one million songs.
For the broader indexes the weeklong bounce appears to be fading. The Dow resistance at 10400 held on Friday and we have see a pattern of lower highs as this week unfolds. Today's lower low came after three days of stagnation just below that 10400 resistance. Support remains in the 10000-10100 range and that gives us plenty of room to wander with no real market moving economic reports to trip over until Friday.
The Nasdaq actually held support at 1960 despite the -17 point loss. This is a bullish sign but it is also fighting a strong downtrend line from January. With techs normally weak over the summer months this relative strength today in the face of the Dow drop was encouraging. The Cisco news was a mixed blessing with slightly higher earnings and guidance. They benefited from several big deals with British Telecom, Sprint and Merrill Lynch that help them produce those results. Overall the +10% guidance for the current quarter was higher than analysts expected but less than exciting. CSCO rose and fell in after hours and ended just about even. This should be neutral to the market but then without any CSCO excitement to pump up the market the fear of summer could hit soon. Chambers will be on CNBC tomorrow morning and he always tries to paint a positive picture so anything is possible. The SOX is clinging to the 395 level and refusing to drop and that always provides comfort to tech bulls.
The S&P futures took a dive after CSCO reported to trade at 1164.25 but have recovered slightly to 1166.50 and even for the session. This suggests the knee jerk reaction to the hedge fund story has not developed into a tsunami, yet, and there is nothing on the horizon tonight that spells doom for the bulls. I do not believe the hedge fund story is over yet. The WSJ said they were updating their hedge fund report with a new article in tomorrow's edition that will name names and provide more details. This could calm troubled waters or churn them up into whirlpool status.
On Sunday I suggested shorting any bounce to resistance on Monday/Tuesday and I hope everybody took that advice. I don't see any catalyst that could push us over Dow 10400 but if lightning strikes we have much stronger resistance at 10500. I would continue to be wary of any bounce and my bias is still negative until that resistance breaks. We had a nice rebound from the April lows but buyer conviction is still very weak. Until the bulls find enough courage to put some volume on the board any rally is likely to fail.