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Market Wrap

Buying Opportunity?

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Buying Opportunity?

The investment press spent the last three days whining about the strong market drop and each commentator seized on one of about six different key reasons they felt the market collapsed. None that I saw really saw the big picture. Or maybe they were seeing too much of the big picture and were not focused on the real culprit. Various reasons given included $60 oil, protectionism, weak economics, rising dollar, CNOOC and Unocal, Greenspan comments, etc. Which do you think was the real cause of the drop?

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The Nasdaq climbed to new five month highs on Thursday at 2106 and just as euphoria was taking hold somebody knocked the ladder over. The plunge was sharp and selling continued steadily into Friday's close. The Dow came within a couple ticks of 10650 again on Wednesday and was doing a very good job of holding over 10600 until the sell programs appeared on Thursday. Did something Greenspan say suddenly cause a million investors to rush to the sidelines? I think not. Was it the China bashing that jumped to the front page when CNOOC made its offer for Unocal? I doubt it. Surely it was the August contract for oil hitting $60 that greased the market skids. Wrong again Kemosabe. (Tonto's name for the Lone Ranger for those of you born after black and white TV went the way of the dinosaurs) If it was $60 oil then why did the markets reach new highs later in the week after that same $60 level was touched on Monday? So many excuses, so little grasp of reality. I will try to touch on them all. 

First the economic picture is slowing as evidenced by several events of the week. The Durable Goods headline number on Friday soared by +5.5% giving the appearance of good news. Under the hood the internal components told a much different picture. The core capital goods, which are comprised of nondefense capital goods excluding aircraft, FELL -2.3% for the month. This is the REAL indicator of production growth not the headline number. New orders for computers and electronics fell -1.2% after dropping -6% in April. A huge increase in orders for Boeing raised the transportation component +21.2% for the month to provide the headline bounce. If anything this should have been somewhat favorable to the markets as it suggests the Fed could quit hiking rates much quicker than we discussed just last week. I do not believe this was a major factor for the market drop. The drop began a day before this number was announced. Did it add to the already negative trend? Probably, but not a major factor. 

On the economic side of the ledger we have to consider the impact of the FedEx warning on Thursday. FDX said that higher fuel costs, slowing shipment rates and aggressive competition had blunted their previously rosy outlook. The stock took nearly a -$10 two day hit and settled at $80 on Friday. The transports took a -150 point hit and closed at two-month lows. The impact of high oil was a factor but the sell off was related more to slowing shipments as a sign the economy was slowing. 

Oil over $60, who would have thought? (grin) The oil bears are busting out all over but bearish on production not on prices. Bad news seems to beget more bad news and the comments I have been posting for a year are slowly gaining more credibility in the mainstream media. Hardly a day goes by now without some story critical of future demand or current production. The August crude contract bumped against $60 multiple times this week with the December contract closing at $61.15. Both contracts posted new closing highs. Boone Pickens face was plastered across all the networks on Friday with predictions of $3 gasoline this year and $100-$120 oil within five years. Nice to have the experts in the field agree with your own predictions. Invested in oil yet?

August Crude Oil Chart - Daily

December Oil Chart - Daily

China's CNOOC bid for Unocal ignited a firestorm of China bashing and calls for the administration to veto the deal on the grounds of national security. Personally I strongly agree. I have mentioned in these pages many times over the last year that I expect the U.S. to be in a shooting war with China over oil within ten years. I strongly suggest we not give them the oil (Unocal) with which to power their war machine as that shooting war gets closer. China just contracted for 40% of the future production of Canada's Northern Lights oil sands. They also just contracted with Venezuela for delivery of oil to China and agreed to invest billions in Venezuela to secure those rights for decades to come. There are only so many sources for oil in the world and China is rapidly trying to acquire as many as possible to guarantee their own future. On Tuesday night I discussed the rapid buildup in their armed forces and some of the details that were specifically dangerous to the U.S. Is anyone else connecting the dots here? 

While on the topic of China and Unocal have you noticed that UCL has not risen much since the CNOOC bid? CNOOC bid $67 per share compared to $60 offered by Chevron. Many think these bids are out of sight and obscene. "Who really wants to buy an oil company at the top of the market" is what many so-called analysts are saying. To put things in perspective the CNOOC bid only equates to $11.50 per barrel of proven Unocal reserves. Do the math Chevron could afford to pay a lot more but they don't need to. The lack of a jump in UCL highlights the very strong possibility that the CNOOC bid will not get through the approval process. It also represents some disappointment that the bid was not as high as expected with some estimates over $70. 

To put this scenario into perspective requires a divergence from just the oil conversation. The committee meeting where Greenspan and Snow were grilled on Thursday outlined several major problems with China. The high profile oil play just pushed everyone over the edge. Various officials have been waging verbal war with China over the valuation of their currency for several years to no avail. The suggested 27% tariff on all China's products would be a massive overkill and could cause serious economic problems both in the U.S and around the world. China's leaders are not stupid and they have a very large weapon at their disposal. They currently hold over $625 billion of U.S. debt with $200 billion in U.S. treasuries. Just a suggestion that they could reevaluate their dollar denominated debt could send strong ripples through our financial markets. While I don't think they would intentionally cost themselves billions by playing that trump card it is entirely possible they could hedge against that event before actually playing the card. 

Since trade wars typically are not won with a single shot there is a very strong possibility that we will see escalation by both sides if it appears the Senate vote in late July will pass. For instance, should the U.S. pass a tariff against China then China would likely return the favor with a tariff against U.S. products. How competitive would Cisco and Dell be against the Chinese cloners with a 27% tariff on our products going into China? China is a huge consumer and they are trying to convert one billion lower class citizens into middle class consumers. I feel the imposition of a tariff against China would be the first blow that would eventually turn into an economic war. Therefore I don't believe the tariff will ever pass. It is not smart to intentionally aggravate the biggest kid on the block and kicking a sleeping bear is always dangerous. It makes no difference that they have a total disregard for copyright laws and copy/steal everything possible. It makes no difference that they intentionally manipulate their currency to provide a competitive advantage. The answer to this problem is continued diplomatic pressure as they mature into the dominant power on the planet. 

The tariff conversation may have had some negative impact to the market but any real economic impact is still to far away to be seen. If there was any impact it was an emotional knee jerk reaction only. So, if the market did not drop on oil, economics or tariffs then what killed it? I personally believe it was time for profit taking and that profit taking was accelerated in a large way by the Russell rebalance. I have speculated for several weeks that the markets were long overdue for a pause. The 10650/2100/1220 resistance was rock solid and June was rapidly expiring. That should not have been the reason for the severity of the drop. If anything we should have seen a continued underlying bid as the end of the quarter and end of half window dressing took us into July. The disappearance of the bid may have been due to oil, economics and tariffs but the selling came directly from the Russell rebalance. 

I expected it to appear sooner and we entered a DJX put play two weeks ago in the Leaps Trader section in anticipation of this drop. I believe the bullish markets kept funds from selling on hopes of capturing that last penny of profit before being forced to swap stocks for the rebalance. With the inchworm moving ever closer to a breakout they were hoping for that last burst of short covering to pad their accounts as resistance broke. What they got instead was a dead stop at resistance with Nasdaq 2100 and S&P 1220 as solid tops. When the breakout over 2100 failed on Thursday morning they pulled the sell trigger and their program trades ruled the rest of the week. Dip buyers were methodically hammered on every bounce and we ended up with the worst drop since April with the Dow losing -2.8% for the week. I believe oil, economics and tariffs may have captured the headlines and removed the bid but the Russell rebalance was the final culprit. 

If I am right we should see a rebound on Monday. Despite a Fed meeting on Tue/Wed we still have the end of quarter window dressing ahead. It is also entirely possible the Fed could blink in their statement given the recent economic weakness and suggest they are nearing an end to the measured pace hikes. This would also stimulate the markets into the Q2 earnings. 

The downside to Q2 earnings is the falling expectations. Current earnings are only expected to show +10% to +12% growth compared to over +20% in Q1. Warnings have been accelerating and next week should be a prime warning week on the Q2 calendar. I expect most of those warnings to be ignored. Granted a high profile tech warning could do serious damage but I think most investors are already factoring in a slow summer. 

While I believe $60 oil was only a minor factor this week I would expect any move over $60 to create substantially more stress. $60 should be a psychological roadblock and a break higher would confirm the bearish production concerns. We are too far away from the fall demand spike to already be over $60. I was not expecting that until August. A breakout now suggests we could see $75 by October. This is a very serious problem for the transportation sector and for many businesses. Higher fuel costs raise the cost of every product that is made with oil or shipped to market. Diesel is very close to an all time high and could break that high next week. Overall distillate demand is up +7% year over year for the four weeks ended June 17th. Gasoline demand is up +2.5% despite the huge rise in prices over 2004 and diesel demand is up +6.9% year over year. Valero, a large U.S refiner said this week that output of diesel nationwide should drop about -3% in 2006 due to much stronger regulations about the sulfur content of diesel. Just what the markets needed to hear. Jet fuel demand is up +31% year over year and up +91% since the same period in 2001. U.S. oil production fell last week to an average of 8.7 mbpd, down -255,000 bbls from the prior week. With gasoline demand expected to increase sharply with the July-4th weekend ahead the inventory levels are expected to drop again. There is nothing positive in the near term outlook that should cause oil prices to fall. This should keep oil prices in the headlines for at least two more weeks and continue to pressure those stocks/sectors that depend on oil. Michael Economides, Professor of Petroleum Engineering at the Univ of Houston said $70 was the next target. He also said, "oil is not going down and that is the end of that story." 

My outlook continues to be for a late summer decline unless we see a strong surge in Q2 earnings that surprises everyone. The May rally gains are at risk and there are plenty of news headlines to provide the pressure as we move into mid July. Personally I see Monday as a short term buying opportunity as laggards continue to buy Russell stocks to complete the rebalance. The actual weightings were not known until the close of business on Friday. The Nasdaq closing numbers are used for the final weighting calculation. This can produce another round of positioning on Monday and that positioning should have an upward bias. (keyword is should) I would look to buy any bounce for a four to five day trade and keep a tight stop. The next series of potholes are the Fed announcement on Wednesday and the ISM on Friday. An ISM headline number under 50 could be the last straw for any bounce. The various jobs numbers are out on July-7th/8th and any weakening could apply more speed to any July decline. The Nasdaq retreated to initial support at 2050 and a good launching point if the decline was only Russell related. The next Dow support is in the 10150-10200 range and that suggests the market could open Monday looking at the Nasdaq for leadership. The SPX could also help with Friday's close on recent support at 1190. 

SOX Chart - Daily

Russell Chart - Daily

If you are looking for something specific to trade I would think about EBAY. Ebay had their 10th annual convention this week and there were numerous positive developments. David Faber on CNBC will have an Ebay special on June-29th similar to the Wal-Mart special they ran almost daily for months. I expect this to provide a positive boost to Ebay stock. The bottom fell out of Ebay this week with nearly a -$4 drop. Most of the drop was in the last two days and was likely Russell related. With large companies going into the Russell-1000 the weightings for all other stocks changed drastically. Internet stocks like Ebay and Yahoo were hit hard. The July $35 call XBA-GG was trading at 95 cents on Friday when I recommended it in the Market Monitor. EBAY closed at $34.31. I believe now that the rebalance is almost over and the CNBC profile event is scheduled for next week it is very possible we could see a significant bounce. If the short time frame scares you there are many other strikes available. 

Until November we want to continue buying oil stocks on any pull back and holding them until year end. Looking at an oil chart it appears more likely there is more upside given the holiday demand ahead. Buying now rather than waiting for any post holiday dip would also be an option. I sure wish I could get the same $11.50 a bbl price CNOOC is offering for Unocal but I don't have that kind of buying power. One analyst speculated that the loser on the Unocal deal could shift their sights to Marathon (MRO) given their diverse operations and market cap. Just a parting thought for those that need a little extra incentive to buy oil at this level. Until Tuesday remember to enter passively and be ready to exit aggressively if conditions change. 


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