Option Investor
Market Wrap

Right on Schedule

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The market rebounded right on schedule after six days of declines. The end of quarter window dressing sent shorts scurrying for cover as broad based buying took hold. It was clearly fund shuffling with cyclicals, industrials, basic materials and other beaten down stocks suddenly finding buyers while the recent high rollers saw profit taking. The Dow sprinted to its largest one-day gain in six weeks. Up volume was 4:1 over down volume. This is a major rebalance week as it gives funds an opportunity to put their best face forward to investors just before the historical sell cycle leading into the August-October dip. Those buying the dip as I suggested on Sunday are holding a nice gain. 

Dow Chart - Daily

Nasdaq Chart

SPX Chart - Daily

Bill Gross escalated his critical rhetoric today with comments that the Fed was pushing us into the next recession. Talking down the economy is good news for bonds and Pimco is the largest bond fund in the world. Kind of makes you go hmmmmm? Gross suggested we were only 1-2 years from a recession and the economy was running on borrowed time and borrowed money. Slowing growth, rising interest rates and rising oil prices pose the biggest risks. Gross pointed out that the U.S. typically cycles into a recession about every 7-8 years. According to Gross we are currently 4.5 years into the current recovery and 2006-2007 will be high risk for the beginning of the next recession cycle. Coincidentally 2007 is widely seen as the crisis point for peak oil. So far the end of this decade is not shaping up well. 

Fear not, consumers unconcerned about the future, shrugged off high gasoline prices and constant whining by housing bubble crowd to push Consumer Confidence to three-year highs. June Consumer Confidence soared to 105.80 from earlier reading at 103.1. On the downside the consumer view of the job market deteriorated slightly. Why confidence surged while oil was nearing $60 again is baffling to almost everyone. 


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GOOG continued to move higher at the open with a print over $309 on thoughts that S&P will add them the S&P-500 when their one-year anniversary as a public company passes on August 13th. To be in the S&P the company must have four quarters of results as a public entity. GOOG is the only major Internet stock trading higher for the year. Amazon is down -38%, EBAY -43%, IACI -11% and YHOO -5%. Notwithstanding its sky high price over $300 Google still trades at a PE less than the other four. Despite the triple digit gain on the Dow and +25 on the Nasdaq, Google declined to close right at $300 for a -2 loss and well off its highs. 

GM may have struck a nerve with their employee discount program for consumers. Dealers reported a strong jump in sales for June and GM is expecting its best month in years. The percentage of buyers moving from non-GM cars to GM rose from 39% in June 2004 to 57% today. Those buyers who would recommend their dealer to others rose from 68% to 87%. The real key appears to be customer satisfaction with price. Those buyers haggling over price dropped sharply from 68% to 51%. It would appear that customers are generally happy with the current employee pricing scheme. Analysts were quick to point out that late summer buyers, those that plan on buying a new car for a steep discount as the dealers try to make room for new 2006 models, have probably just moved their buying decision ahead by 60 days to take advantage of the short term employee pricing deal. The real key for GM will be sales in July and August.

Petrokazakhstan (PKZ), a Calgary Oil company with operations in Kazakhstan, has soared over the last two days with rumors flying that a takeover bid is just ahead. PKZ has jumped from $32 to $39 after PKZ acknowledged it was in talks with different companies about a merger or acquisition. The oil patch is ripe for acquisitions since buying oil reserves is far easier than finding the dwindling deposits. 

AMD filed a suit against Intel claiming Intel was unfairly preventing companies from buying their chips. AMD listed 20+ companies that had been bullied by Intel into exclusive deals excluding AMD chips. Intel reportedly threatens companies with higher prices, loss of advertising revenue and loss of allocation priority if companies offer AMD chips in their products. Many companies receive millions in co-op advertising dollars, sometimes in the tens of millions to keep the Intel name in front of consumers including the "Intel inside" campaign. This co-op advertising is critical for box makers fighting for every penny of revenue in an extremely competitive sector. Companies reportedly under the Intel gun include BBY, CPQ and Dell. Japan just ruled against Intel saying their actions in Japan were anti competitive. Intel did not appeal the ruling and that gave AMD additional incentive needed to launch its suit. The suit is not expected to come to trial until late 2006. Consider this point. If AMD actually had the better chip at cheaper prices they would be selling those chips instead of suing Intel. Companies would be switching to AMD for performance as well as higher profits. I thought they were closing the gap or even ahead in some areas but today's suit makes me think they are throwing in the towel. 

Richard Scrushy, founder of HealthSouth was found not guilty on all counts. Scrushy was charged with 36 counts on conspiracy, mail fraud, accounting fraud and for violating the Sarbanes Oxley act. This was the first violation of Sarbanes Oxley ever to be prosecuted. TV Commentators were unanimous in their amazement and condemnation despite his vindication in the $2.1 billion scandal. Meanwhile Bernie Ebbers faces 85 years in jail. 

Window dressing boosted cyclicals on Tuesday in anticipation of a benign FOMC meeting this week. The Fed has a two-day meeting this week ending on Thursday and they are expected to raise rates another quarter. What investors are hoping for is another statement that confirms the economy is still moving forward and they either retain the measured pace language or give indications they are about done with their hike cycle. Personally I think the chance the Fed will blink is mostly wishful thinking. This weeks meeting should be market neutral unless the Fed statement changes materially. Ironically the meeting announcement also falls on the last day of the month to give hedge funds one more headache. 

August Crude Oil - Daily

Oil prices fell ahead of month/quarter end as traders took profits from the record gains. Several analysts took to the tube today with comments that oil could fall back below $40 by year-end. I hope they are keeping their resumes up to date because any shorts entered on the chance of oil returning to $40 are not likely to prosper. Everyone invested in oil knew the breakout over $60 was begging for profit taking heading into quarter end and that is exactly what happened. Funds window dressing for quarter end needed to take some profits and spread the cash among some non-energy issues to appear more diversified. Helping accelerate the decline were some comments from OPEC members suggesting some additional supply could be coming online. Sure, and the tooth fairy will be visiting us soon. If you watch closely you can tell when OPEC officials are lying. Anytime their lips are moving they are lying or at least evading the truth and trying to protect their carefully constructed oceans of oil faade. Putin also made a comment that suggested Russia might be interested in producing some more oil for export. There were also comments from Nigeria about output levels. It is amazing how many oil moths were attracted to the microphone by the flame of $61 oil. Technically the comments triggered a sharp dip, which in turn triggered trailing sell stops and stop losses. This along with end of quarter portfolio shuffling caused a cascade in prices. No magic here despite the continuous coverage of the drop on stock TV. 

Oil inventories on Wednesday are expected to show a build in crude and distillates now that all the gulf production is back online from the first storm of the season. If the build does not appear we could see today's losses regained very quickly. August Crude fell -$2.34 to close at $58.20 and the biggest drop in eight weeks. December crude slipped to close at $60.25. I still consider every dip a buying opportunity as global demand is continuing to rise faster than production. We already know the end of this story, only the exact timeline is unclear. A dip to the 100 day average at $54 would be an excellent buying opportunity but I am not holding my breath. 

Two letters appeared today that were critical of the CNOOC bid for Unocal on National security reasons. Representative Joe Barton from the House Energy and Commerce Committee co-authored a complaint saying China was NOT a friendly trading partner with a free market economy but a communist rival not to be taken lightly. Amen! CNOOC is 70% owned by China despite its appearance in the costume of a NYSE traded company. CNOOC (CEO) jumped +$3.20 after CSFB raised its rating on CNOOC to outperform from neutral saying the bid was smart and well structured with less equity dilution than earlier feared. Macquarie Research analyst Scott Weaver said CNOOC had a good chance of winning as it had a "stronger incentive" to win and the financial support of its parent. This is the same parent government that brought us Tiananmen Square several years ago. Those agreeable to the acquisition point out that Unocal supplies only 1% of U.S. demand. What they don't say is that it currently supplies about 450,000 bbls of daily global demand. What they fail to understand is what happens if China was to take that global supply out of the market. They could simply reduce production to preserve the oil for their future use. Nothing says they HAVE to pump it today. Take any oil out of the global pipeline and you cause global problems not just in the U.S. If Unocal suddenly quit supplying oil to other countries those countries would then be forced to bid higher for oil currently heading in our direction. We may only get 1% of our oil from Unocal but the impact globally could be more painful. Can the U.S. afford to take the risk? Can the U.S. afford to give a communist country access to resources that could cause us serious grief if they were cut off? 

The Dow rebounded from its 10253 lows on Monday to close over 10400 once again. However, that 10400 level did appear to attract sellers as the afternoon progressed. The Nasdaq rebounded to 2070 with a gain of +24 points and advancers 2:1 over decliners. It was a strong move but like the Dow it seemed to run out of steam once it reached 2070. The SOX recovered slightly to 425 but remains stuck in the middle of its recent range. Semiconductor billings are due out later this week. 

The Russell was a big winner as expected with a gain of +13 points to 641. Those funds waiting for the smoke to clear from last Friday's rebalance were faced with rising prices as they rounded out their index adjustments. Many funds wait until after the event to buy the additional shares hoping to capitalize from over buying by arbitrageurs. Many hedge funds race to buy up potential additions to the indexes on the first announcement with the hopes of selling them into the Friday rebalance for a profit. If there are more sellers than buyers into the event then the hedge funds are faced with unloading those extra shares. This depresses the following Monday and many index funds try to slip in unnoticed with the unloading in progress. Tuesday saw additional buying as those with overly aggressive expectations of a Monday dip were left unfilled and chasing the new stocks higher. 640-645 is very strong resistance on the Russell and it will be interesting to see if the rebound can continue. 

Russell-2000 Chart - Daily

Transports reacted to the sharp drop in oil prices with a huge +85 point gain. I feel this was more window-dressing initiated than a mass hallucination that oil was going to return to $40 soon. In reality there was a large short interest in transports with oil over $60 and that trade was temporarily erased as shorts were forced to cover. 

The rebound was attributed to equal amounts of oversold conditions and window dressing but there was still a lack of real conviction. The lingering Fed cloud this week could be one excuse but I believe there is more earnings fear than Fed fear. The earnings expectations have been slipping and the ratio of warnings to positive guidance at 2.7:1 are the highest in eight quarters. With the summer doldrums still ahead we are either setting up for a textbook slump into the Q4 rebound or a possible contrary bounce on better than expected earnings. Expectations have fallen to the point where we could see a surprise rebound if earnings come in better than expected. With the S&P earnings currently predicted at slightly more than 10% growth there is not a lot to be excited about. If you take the energy stocks out of the calculation you end up with nearly flat earnings for the quarter. Energy companies, especially the integrated oils, are expected to raise estimates for Q2 given the high oil prices. Many of the oils have been growing earnings by +30%, +40% or even +50% per quarter. Take a dozen of those out of the S&P total and the earnings growth average for the remaining non-energy companies will shrink substantially. 

I suggested on Sunday to go long on Monday for a potential four to five day trade. On Monday we got an excellent intraday dip to Dow 10250 for an entry and a closing rebound to setup today's bounce. While I would like to see these gains continue we are in the middle of warning season, a Fed meeting, quarter end and month end. The month end carries substantial risk as we get the GDP, ISM and Jobs numbers over the next week or so. After today's big gains I would suggest you tighten your stops and don't get too attached to your positions. There is high risk ahead for anyone on the long side of the market. Ride it as long as it lasts but be ready to exit aggressively if the direction changes. 

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