Option Investor
Market Wrap

Slowly Creeping Higher

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The bulls continue to push the market higher but at a very slow creep. Instead of two steps forward one-step back it is more like 10 steps forward 9 steps back. Several strong buy programs have pushed the market higher the last three weeks but all were almost completely erased before the close. On Monday we saw an 80-point Dow gain reversed to end up only fractionally. On Tuesday a morning buy program spike was almost completely erased only 30 min later. Still the underlying bid remains and the inchworm continues to climb higher. 

Dow Chart - Daily

Nasdaq Chart - Daily

The broken record of mixed economics continues to play with the PPI falling -0.6% in May and erasing the +0.6% gain in April. The consensus was for a minor drop of -0.2%. Today's number was the biggest drop since April 2003 and took some inflation fear out of the market. Unfortunately the drop came on an easing of energy prices in early May and that dip has been completely erased. Heating oil is still up +44% over last year despite an -8% drop in May. With worries about shortages this fall the prices are not going to fall far before surging to new highs. Consumers hoping to fill tanks early this year to take advantage of the drop in prices had better hurry. Conditions in the oil market are accelerating rapidly. 

For the same May period retail sales fell -0.5% and also well below consensus estimates of only a -0.2% drop. Falling sales in Gasoline, autos and apparel led the declines. Colder weather than normal put pressure on summer apparel sales. High gas prices kept consumers from car shopping and put the squeeze on non-essential driving. The biggest gainer was building material dealers as the summer building season got underway. 


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The economic calendar picks up on Wednesday with the CPI, Mortgage Applications, Business Inventories, NY-Empire Mfg Survey, Industrial Production, NAHB Housing Index, Beige Book, Quarterly Services, OPEC meeting and Oil and Gas Inventories. It is going to be a very busy day. 

The current OPEC outlook is for an immediate increase of +500,000 bpd to 28mbpd. Nobody expects to see a drop of additional oil since current production already exceeds this level. It is merely a move to put the production quota more inline with actual production. There is also a consensus for another +500,000 upgrade as early as July in an effort to build inventories well in advance of the fall demand cycle. OPEC expects demand in Q4 to increase by +1.5 mbpd over 2004 and there are some serious worries that OPEC will not be able to keep up. The IEA estimates Q4 demand will increase by 1.6mbpd. China and the U.S. are going to be adding oil to their strategic petroleum reserves in August to the tune of more than 100mb. This should put a serious crimp in any excess inventory. OPEC members being interviewed on the street actually expressed concern that they would not be able to meet demand. This is a huge change in posture given the oceans of oil comments in the past. 

There are growing claims that the Saudi fields are in decline and they have been damaged by pumping at peak production for the last year. Current estimates are for an -8% annual decline in production from existing fields due to declining output, field damage and excess water injection. With Saudi currently pumping just under 9mbpd that -8% decline equals nearly -750,000 bpd this year and that percentage increases every year. Saudi had previously said it would add +5 mbpd of production by 2012 but recent comments suggest that only +800,000 bpd of light crude would be added during that seven year period. That increase was from improvements to two existing fields but experts are now saying that the number will be less than 400K total. With the -8% annual decline in existing fields reported above it actually means Saudi output will be losing about -3mbpd over the next five years. That +5 mbpd was to be the result of new exploration and development and as such is still in question. Even if it comes to pass it is still very far away. The Saudis are actually already using water injection in a new well that just came online. This proves there is stress to produce because water injection is only used for late stage wells as it hastens the eventual decline. It appears the cracks are appearing in the Saudi claims for oceans of oil. Either that or their ocean has sprung a leak. 

Crude rose to $56 on Monday on supply comments from OPEC members and fears that the heating oil demand was going to be early this year. It fell only slightly today to close at $55 ahead of the oil inventory numbers tomorrow. The gulf storm failed to cause any real damage to platforms but there were still some production facilities closed as of late today. Everything was expected to reopen later in the week. Still, much of the production in that region was shut off for several days and we don't really know how the inventories will be affected. December crude, the real contract to watch for end of year shortages settled at $58 after hovering just under $59 on Monday. 

December Crude Contract 

In the endless discussions of oil on CNBC this week there was one in particular that struck home. One analyst was talking about increased security in Saudi on the basis of increased threats. Robert McFarlane, former National Security Advisor, said any average terrorist shooter could drop a few mortar rounds into Ras Tanura in less than a minute that could take 6-9 months to repair. Ras Tanura is the oldest Saudi refinery and the second largest. A shutdown of this refinery would be a crippling blow to Saudi production and its ability to meet demand. He predicted $100 oil almost immediately should an attack like this occur. Personally I believe it is only a matter of time before these high profile refineries become targets and terrorists will probably wait to strike when demand is greatest and the most damage to prices will occur. 

The Saudi oil minister at the Vienna OPEC meeting was literally begging for new refineries to be built. The problem remains that they are depleting the "light" oil that most global refineries can process and the remaining Saudi production is the heavy sour crude that costs more to refine. There is a real shortage of those refineries and Valero, a current LEAP play, is the largest in the U.S. While other refineries will end up begging for light crude before the year is over Valero will have no shortage of heavy crude and that puts them in the right place at the right time. They buy the heavy crude much cheaper but the refined gasoline still sells for the same premium prices other light refiners will be getting. Essentially Saudi is right. If more refiners would switch to process sour crude it would extend the peak oil date by several more years. Unfortunately it costs more than a billion dollars to make the conversion and it produces substantially more environmental pollution for the plant. This prevents many existing refineries from wanting to make the switch or get the permits. The bottom line is still an impending oil disaster over the next two to five years that will make the bursting of the Internet bubble tame by comparison. 

In other stock news today the biggest winner was Best Buy, which surged +8.68 after reporting a +85% jump in profits on rising margins. BBY had shifted strategy over the last couple years as it fought with competitor Circuit City for market share. The most improvement came in sales of digital music players, digital TVs and video games. Same store sales rose +4.4% year over year and that was on top of +8.3% gain the prior year. For the 67 stores fully converted to their customer centric model the same store sales were up +9%. Its newest customer centric ploy was the formation of the Geek Squad where BBY hired 8,500 technicians to perform upgrades and repairs both in store and at customer sites. Geek Squad revenue has more than doubled since last summer's rollout of the service. Today's strong jump to $67.81 marks an all time high. Circuit City reports earnings on Friday and they should be interesting. BBY results are going to be hard to top. Puts anyone?

Another previous high-flyer, Krispy Kreme, fell -8% to $7.86 after warning that sales had fallen another -17% and they would lose more money in the current quarter. JP Morgan said, "Business conditions remain very poor with no sign of improvement," and "Continued financial viability of franchisees is a major issue." KKD hit a high of $49.74 in 2003 but its donut business is turning stale as it follows the Boston Chicken model into oblivion. Run, don't walk to the exits. 

The Russell surprised everyone so far this week with a +10 point spike instead of a -10 point drop. Historically the Russell rebalance tends to pressure the index as stocks being removed are sold. Evidently there are enough intra index changes between the Russell-1000 and Russell-2000 as well as capitalization changes to require fund managers to buy more at the top end of the 2K than they are selling at the bottom end. The Russell broke over 630 resistance today and closed at 634. Major resistance remains 640 but if the trend continues that could be an intraday bump in the road. The all time high was 656 was set last December. The Russell had paused at just over 620 while waiting for the rebalance announcement but after closing at the high for the day and a three month high there appears to be no looking back. 

Russell-2000 Chart - daily

SOX Chart - Daily

The SOX is doing the reverse of the Russell with a drop to 425 and a three-week low. This kept the Nasdaq in negative territory most of the day with the +0.08 close only a minor victory over the sellers. The Nasdaq rally in May has confounded the experts. There were few reversals to consolidate and those that did appear were short and shallow. Without any backfilling most analysts are suggesting there is a new correction in our future. Instead what we are seeing is consolidation in place with no real selling. This is keeping the bears off guard given the very real occurrence of buy program induced short squeezes we have seen over the last couple of weeks. No good spike has gone unpunished but the bears have yet to be able to gain any traction to the downside. The best they have been able to do is push the index back into its recent consolidation range. They say don't short a dull market and our markets have definitely been dull over the last three weeks. There have been five certified short squeezes caused by buy programs since May 24th. None have lasted and the Nasdaq closed today only +7 points above the close on May-24th. Three weeks of relative boredom interspersed by five hours of sheer terror for the bears. Each buy program squeeze buoyed bullish hopes but lasted barely more than an hour. If we are having fun now I can't wait until the summer doldrums arrive. 

Unlike the Nasdaq the Dow is starting to show signs of progress with progressively higher highs, if only by a handful of points. The last two days have found rising support just over 10500 and an assault on 10600 appears to be in our future. There is also a nice progression of higher lows dating back to that May-25th dip and unlike the Nasdaq each buy program spike was not completely retraced. This is a strange set of circumstances for an early summer market. Given the Greenspan comments on further hikes and the lukewarm Intel update the markets are actually behaving rather well. 

I said on Sunday that I saw bullish internals under the market and the potential for a continue move higher overcame much of my bearish bias. I believe there are quite a few sideline bears beginning to see the light and the next breakout, over 10600, could attract a lot of attention. To me the Russell was the key. With the Russell expected to dive on the rebalance news most traders were short heading into the news. Heck, I wanted to be short it today but it was a losing proposition once the afternoon rebound began. 

I believe we are rapidly reaching the point where a directional move will occur. While my bias is still "emotionally" to the downside I am not going to fight the tape. Should the Dow break over 10600 I believe we will see traders begin to chase price and that tends to produce a new leg up. I am not yet convinced the breakout will happen but if it does and with the help of the Russell we may see the SOX/Nasdaq sellers get caught in yet another squeeze and one that may stick. To temper any excitement I may have imparted I still believe we will see another bout of profit taking and portfolio rebalancing in the July-Sept time frame. The flurry of economic reports on Wednesday could change market sentiment drastically so, like always, enter passively and exit aggressively.

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