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Market Wrap

Good News Priced In?

HAVING TROUBLE PRINTING?
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The markets dipped on Friday after a week of positive news and high profile events. The Greenspan speeches calmly erased the eighth inning comments from Fisher and the Intel update was seen as less than exciting. Positive guidance from a handful of chip stocks failed to prevent the SOX from selling off once again. In short it appears the good news was already priced in given the May rally and Greenspan provided the final blow. However, the resilient bulls refused to accept defeat and that is the real news this weekend. 

Dow Chart - Daily

Nasdaq chart - Daily

On Thursday Intel raised its earnings guidance to the high end of its prior range citing the strong demand for notebooks using its Centrino chips. Unfortunately that news was already known and the upgraded guidance was already expected. Intel had rallied for four weeks straight and topped just under $28 on June 3rd as investors hoped for some blowout news. The lukewarm report failed to impress and Intel fell nearly -$1 intraday on Friday and broke support at $27 only to return there at the close. Other chip stocks giving positive guidance this week included TSM, LSI, TXN and NSM. Despite this positive guidance the SOX found itself well off its multi month highs at 440 and threatening to break support at 427. 

SOX Chart

Helping create this chip swoon was news out of Merrill that they were still recommending an underweight in tech stocks. They claim the current valuations were swelled by hopeful buyers but they are not supported by fundamentals. Merrill feels the negative economic momentum may slow tech spending at a time when the stronger dollar is already hurting tech profits. Tech mutual funds have seen outflows for nearly all of 2005 with only a handful of weeks seeing marginal inflows. This continued caution on techs after a lukewarm update from Intel prompted some weak profit taking from the May rally. 

Greenspan erased the optimism created by Fisher that the Fed was nearly done raising rates. Greenspan calmly repeated the measured pace language and reiterated the "data dependent" clause that could change the Fed posture. He made his comments so slowly and cautiously that there was not big reaction by the markets but the result was the same. The Fed funds futures are now back to pricing in three more rate hikes at the next three meetings, June, August and September. The November and December meetings are questionable but the futures are suggesting at least one of them will contain another hike. This reversal of fortunes for traders from expecting only one more hike last week to the current possibility of four substantially depressed sentiment despite the lack of reaction by the markets. 

The sentiment on Friday was a feeling that the Q2 rally was behind us and there was nothing left to produce excitement heading into the summer. Q2 guidance has been more positive than normal but not exciting. The lurking economic weakness has created concern among traders and most are patiently waiting the next round of economic reports for confirmation of direction. We have three weeks until the next ISM and four weeks until the next Jobs report. This waiting game will be punctuated with many reports of lesser importance but the ISM and Jobs are the reports that will govern our fate heading into Q2 earnings. Not all of Greenspan's comments were negative. He said the economy was on "reasonably firm footing" and inflation remained contained. He also said there was no national housing bubble although there might be some froth in several local markets. This was good news for the housing stocks and relieved some pressure produced by the bubble talk over the last year. 

December Oil Futures Chart

Oil prices have been very volatile with daily news providing no trend. OPEC meets on the 15th in Vienna and they are expected to vote for a production increase. Unfortunately it should not create any new production but only validate the current over quota production by several countries. Saudi is rumored to be producing slightly over 9.5 mbpd and this is right near their maximum sustained output. The IEA said on Friday that demand shrank in China by -2.8% in April but the demand in the U.S. surged to fill the gap. The first tropical storm of the season is heading for Mississippi and several oil companies have begun evacuation of their rigs in the gulf. As a medium strength storm it is not as dangerous as a hurricane but still has the capability to disrupt production for several days and cause damage from high waves. Anyone watching the Oil Storm movie on Fox last week should have second thoughts about any storm heading for that region of the gulf. Nearly two million bbls per day flow through Port Fourchon, Louisiana just offshore from New Orleans and a serious storm in that region could cause real economic problems. That movie echoed nearly all the scenarios I laid out in my Oil Crisis report last December. 

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The FTC approved the merger of Chevron and Unocal and with no time to spare. There was also news this week that China National Offshore Oil Corp, CNOOC, was rumored to be planning a higher bid for Unocal. Part of the future global oil problem is the demand for oil by China. They are aggressively pursuing nearly every major oil reserve across the globe with the intention of locking up production for decades to come. They are trying to work out a deal on Canadian oil sands production as well as several South American fields. CNOOC is government owned and as such has no limit on how much it can pay to capture future production. Given the shrinking global reserves the future goes to whoever is aggressive enough to secure those reserves before the global crisis begins. The U.S. is currently the largest consumer of oil in the world at 22mbpd but China is expected to move into first place by 2025. They are estimated to see demand rise by +8% this year to 7mbpd. Since it is widely known that there is only about 1-mbpd of additional production available China is going to have to act aggressively to acquire the additional 15-mbpd it will need by 2025. Somebody is going to end up short and odds are good it will not be without a fight. China is well behind the energy curve and consumes only 1.7bbls per person per year compared to 25 in the U.S. and 7 in Mexico. Just bringing them up to the level of Mexico would increase their demand to 30% of global production. Given their huge population and rapid growth rate it is incumbent on China to lockup production and reserves far in advance of that need. The problem for us is that every non-OPEC reserve they acquire removes that reserve from the U.S. shopping cart. It does not take a rocket scientist to understand that as available reserves shrink and demand continues to grow prices will rise substantially. China is the biggest problem the U.S. faces with regards to future oil imports and I would be very surprised if we were not shooting at each other within ten years. The oil wars are coming. It is only a matter of time. On a side note China is about done with the first phase of its strategic petroleum reserve. They are building storage for 102 mb and the first phase, 33 mb, will be ready for oil in August. Any guess as to the price of oil when they start trying to fill it? That just happens to be the same time the U.S. is planning on the next round of additions to its 700mb SPR.

JP Morgan said on Friday that the oil sector was ripe for further merger activity given the large amount of cash held by the majors. Takeover targets they listed include SRE, FTO, SUN, TLM, D, AYE and HOC. Energy stocks have surged over the last week on comments that increased profits have pushed valuations even lower and produced even better opportunities. Many stocks have broken out to new highs again and dividends are rising. 

GM exploded higher on Friday after the UAW agreed to negotiate on health care costs. GM claims that $1500 of the price of each car is directly related to health care costs. Last week the GM CEO said he was hopeful an agreement could be reached without having to resort to drastic measures. Those measures could have included a bankruptcy to break the union contracts. Apparently the union was listening and decided to give a little ground on this single point rather than face potentially harsher concessions later. GM soared to more than $35 and a three-month high on the news. Kirk Kerkorian should be happy with his profit on the 18 million GM shares tendered at $31. 

The lack of material market gains over the last two weeks was not due to a lack of bullish sentiment. The Investors Intelligence survey of newsletter writers showed 60.9% of writers were bullish and only 20.9% were bearish. As a contrary indicator this is very bearish to have so many writers in bullish mode. The VXN confirmed this with a drop to a new all time low under 15 several times over the last two weeks. The VXO, old VIX, dipped under 11 twice over the last two weeks and also multi year lows. This excessive bullishness heading into the summer months is contrary to long-term historical trends. However, six of the last seven summers have seen buying in tech stocks, also contrary to long-term trends. This bullishness has also pushed the broader indexes, SPX, Wilshire and NYSE Composite to highs very near to their multiyear highs. Now the question for analysts is will it last? Fund inflows over the last two weeks have been the strongest since February. This is also contrary to normal cycles. 

The Dollar rallied to a nine month high against the Euro on Friday and was partially responsible for the drop in some commodity prices. The yield on the ten-year note rose back over the 4% level with the outlook for rate hikes much more likely. With the Euro breaking down it is being seen as a weaker place to park money for the coming years. Italy wants to return to the Lira and the unification of Europe appears far less certain. This has pushed the Euro lower against other currencies as funds are shifted to other countries. When the dollar was falling on our rising deficit and weak economy there was flight from the dollar to the perceived strength in a united Euro. With rates rising and the Greenspan comments about the soft patch being temporary the dollar has found renewed buyers. 

Russell-2000 Chart - Daily

The Russell rebalancing is upon us and the next two weeks could be rocky for the Russell. Each June the Russell Investment Group revalues the top 3000 U.S. stocks and adjusts the composition of the Russell indexes. The 1000 largest stocks in the Russell-3000 become the Russell-1000 and the 2000 remaining stocks become the Russell-2000. This year 160 stocks are expected to be removed from the Russell-2000 and replaced by others as of close of trading on June-24th. The initial announcement of the stocks being added/deleted was done after the close on Friday. This creates downward pressure on the Russell-2000 for the next two weeks as funds sell to beat the June-24th rush. Since buying in the new stocks does not impact the index until after June-24th their individual gains are not available to offset the index losses. There is also the problem of shifting. As stocks in the Russell-2000 increase in market value they can move up into the Russell-1000 and knock stocks out of the 1000 and back into the 2000. This shifting causes significant churning and that churning does impact the indexes in advance of the June-24th effective date. The Russell Group estimates that more than $2 trillion dollars are indexed to the Russell indexes. There are nearly 3,000 U.S. funds indexed to the Russell and numerous global funds. The Russell method of index structure is different from the S&P. It is based strictly on market cap with very few exclusions for things like shares owned by insiders and share values under $1. All stocks are included unlike the S&P method. Few investors realize that nearly 100 major companies are NOT represented in the S&P-500 because inclusion is done in secret vote by S&P administrators. Companies not in the S&P include GOOG, JNPR, CDWC, AMZN, AMTD, DHI, TOL, DO, DISH, IACI, XMSR, PIXR, WFMI and WYNN to name just a few. In 2004 the Russell-2000 lost -20 points in the week that followed the rebalance announcement. This was right in the middle of a strong +60 point bounce from mid May to July 1st. Beginning on July 1st the reconstituted index plunged from 591 to a low of 515 on August 13th as the summer doldrums appeared. 

Press release from Russell on the rebalancing: http://www.russell.com/US/Indexes/US/Reconstitution/PR_Recon061005.asp

Additions: http://www.russell.com/us/indexes/us/Reconstitution/recon_additions.asp

Deletions: http://www.russell.com/us/indexes/us/Reconstitution/recon_deletions.asp


The Dow hit its highs for the week on Tuesday at 10577 and trended lower the rest of the week. Support at 10435 held and we ended the week just slightly above we started. The Dow would have been much lower on Friday were it not for the +2.75 bounce by GM. Without that bounce the Dow would have been about -25 points lower. After three weeks of trading in a very narrow range I expected the combination of Greenspan and Intel to provide a direction. Unfortunately that did not occur and we are left wondering what catalyst will appear to give us that direction. 

The Nasdaq leadership has weakened and the Nasdaq closed very near to the bottom of its range for the last two weeks at 2060. The Nasdaq appears to be setting up for some profit taking but traders keep appearing right at that 2060 support. The Nasdaq rallied from 1889 on April 29th to 2097 on June 2nd for a +11% move. That rally has yet to see any material profit taking despite the minor post Intel loss. As long as the SOX holds support at 430 tech traders should remain comfortable in their long positions. 

I said on Tuesday that I would attempt to pick a direction today but it is proving very difficult given the numerous conflicting indications. The Wilshire 5000 continues to hold near its highs and showed very little selling. As the broadest market indicator it is not showing any weakness and is very close to breaking out over its 11900 resistance. When coupled with the NYSE composite ($NYA.x) which is also holding very near its highs it appears the broader indexes are suggesting further buying ahead. 

The complicating factor is the gain in techs and the lack of profit taking. While it should be a danger signal it could also be an indication that we are consolidating in place rather than a typical drop/rebound cycle. This suggests the lack of a negative catalyst could see us creep even higher over the next couple weeks as we wait for the June ISM and Jobs. 

If I had to pick a direction this weekend I would say the markets have an upward bias. This is contrary to personal bias but when in doubt don't fight the tape. The market can remain "wrong" longer than you can remain liquid. The indicators that would change my bias back to bearish would be a Dow drop under 10400 and an SPX break under 1190. Over those levels any pullback would be simple profit taking. The Wilshire has support at 11800 and again at 11700. As long as it stays over 11700 any drop in the thinner indexes, Dow and SPX, should remain under control. Last week my plan was to remain short under 1205 and that worked well with a couple nice drops from that level. I still see 1205 as decent resistance and the top of our recent range. That gives us a tradable range from 1190-1205 and one I would continue trading until it failed. While logically I am disposed to the downside the Wilshire is suggesting the breakout could be to the upside. Knowing the ranges allows us to trade either direction with equal ease. 

Wilshire-5000 Chart - Daily

Last year the June highs proved to be the highs for the next three months with a strong dip into August. I am not suggesting that will happen again but we have yet to see a summer swoon and we almost always get one. August, September and October are known for producing yearly lows and I see no reason for that to change this year. Greenspan almost guaranteed three more rate hikes. The ISM is only a point above recession levels and the Jobs report could be setting up for a real shocker on July 8th. If those problems do get worse then we would likely see a serious pullback. Conversely if the ISM and Jobs strengthen and prove Greenspan's claims that the spring soft patch was only temporary then the lows may be behind us. The market exists to confound the most analysts as possible at any given time and the current market message is definitely mixed. That leaves us with only technical trades ahead for June. Trade the 1190-1205 range and watch for a breakout over 1205 or a breakdown under 1190 for the next directional move. As always cash is a position and traders should not get married to their positions. 

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