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Market Wrap

Dennis the Menace Approaches

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What a week! You know it has been a hectic week when the prospect of a weekend hurricane brings only a yawn. As I type this Dennis is heading through the Gulf as a category 4 hurricane with winds of 149 mph and headed right for some serious oil country. However, the hurricane in the Gulf was preceded by a hurricane in the equity markets. After a serious drop on the terror news to 10061 in the Dow futures, 1170 on S&P futures, the markets roared out of the terrorist pit to retest recent highs. The lack of any material pause during this spike points to a serious short squeeze and likely the strongest squeeze so far this year.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The rebound through prior resistance highs on Friday of Dow 10430 and Nasdaq 2100 surprised everyone and caught quite a few bears off guard. The pattern of lower highs on the Dow was leading many traders into thinking the summer swoon was coming early and those bearish on the summer were loading up on shorts. That game plan provided them with a major windfall on Thursday morning but those asleep at the switch when the rebound began were left racing to exit those positions for a profit. As we have seen so many times that once the short covering fire is lit it takes on a life of its own and will continue burning until all the fuel has been consumed. Since many traders refuse to accept the direction change it normally requires a closing bell to quench the fire.

Helping to fuel the fire on Friday was a positive Jobs report. Actually the Jobs number was disappointing for analysts at only +146,000 jobs but it was right in the strike zone for the Fed and for traders. The consensus was for a gain of +180,000 jobs and the lighter than expected headline number was Fed friendly. There were upside revisions to the prior two months that added another +44,000 jobs. The unemployment rate fell to 5.0% and the lowest rate in four years although it was due to slowing growth in the labor force more than an abundance of jobs. We also saw on Wednesday that the layoff activity was increasing slightly with the Challenger layoffs jumping to 110,996 in June from 82,283. This was not a big gain but enough to keep the pressure on job creation and employment in general. Add in the higher price of energy, especially in the gas/diesel area and employer cash flow is being squeezed even tighter over the slow summer months. This makes the +146K in new jobs even more market friendly despite being less than expected.

In light of the Jobs data the outlook for the Fed hike cycle has risen slightly to just under 4% for an ending rate. The Fed funds futures are currently pegged in the 3.82% to 3.85% range for the year-end level. With the economy showing new signs of improvement and the negative reports of April/May disappearing in the rearview mirror like forgotten potholes, traders seem to be accepting the possibility of a 4% rate as a normal business expense. That rate is being priced into the market and from all appearances it is no longer a problem.


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The markets appear more concerned about the coming Q2 earnings than future Fed rate hikes. Thomson First Call said on Thursday that S&P earnings expectations for Q2 are for only +7.5% growth compared to the +13.9% final number for Q1. Given the string of prior +20% quarters in 2004 this is positively anemic. It is not that the earnings are bad but they are facing tough comparisons from 2004 where +20% or more was accepted as the norm. As I mentioned last week the S&P earnings are being bolstered by the energy stocks and without them the number drops sharply. Currently the earnings growth for the energy sector is estimated by First Call at +32%. According to First Call the S&P earnings without the energy stocks are estimated at only +4.8%. The basic materials sector is also supporting the S&P with growth estimates of +23%. Technology is only expected to grow by +11%. As the year progresses conditions are expected to improve. Analysts tracked by First Call predict earnings growth for Q3 at +15.3% and +12.4% in Q4. Typically estimates are trimmed in the middle of the quarter as current conditions are factored in. Still both quarters should remain in double-digit territory. Since investors typically look 6-12 months out this suggests there could be an upside bias ahead.

The wild card for Q3/Q4 earnings remains the price of oil and that is less predictable on a day-to-day basis than the weather. In fact the weather is the current tail wagging the dog. Hurricane Dennis is expected to make landfall in the U.S. sometime this weekend and while it appears to be heading away from a direct hit on the heaviest population of energy assets it is still causing some serious problems. According to the latest reports over 15% of Gulf production is currently shut in and there were late reports on Friday of various oil companies evacuating even more platforms as the intensity of the storm increased. August crude soared to near $62 in advance of the storm but sold off sharply as trading ended on Friday. Speculators took their profit as the bull's eye for Dennis shifted more towards the Florida panhandle than the oil port in Louisiana. Several oil analysts suggested crude could drop -$5 to -$8 if Dennis's bark was worse than its bite.

This has been an interesting week for oil prices with volatility the keyword. The terrorist dip on Thursday sent crude plunging to near $57 after hitting $62.10 in the prior session. Oil stocks reacted sometimes in sharp divergence from the price of oil as option expiration looms just ahead. Profit taking was seen on a sector wide basis after a new series of all time highs for much of the sector. I continue to recommend buying the dips and without any material damage over the weekend we should get another dip next week. Conversely if Dennis, currently the strongest July storm since 1851, puts a long-term dent in Gulf production then $65 oil is just a heartbeat away. Ivan took 500,000 bbls of daily oil production off the market for many weeks and that disrupted the global supply in ways that took the rest of the year to recover. The total lost production was something in the 44 million barrel range. Ivan did not come ashore in the oil belt and that damage was light compared to what could have been done with a direct hit by a storm as strong as Dennis. Fredrick, 1979, was the last major storm to hit the oil belt and caused significant damage.

There was an interesting comment out of the Middle East this week that was generally ignored. Apparently Saudi Arabia admitted there was no way they could pump enough oil to fill the global demand ten years from now. They said current demand growth would exceed available production by 4.5 mbpd in as little as 10 years. Think about that statement for a minute. This was a major reversal from their oceans of oil story. Previously they had said they could increase production to as much as 15-20 mbpd and maintain that production for up to 50 years. That was so much smoke that nobody believed it but it was the party line. Now they are saying they will fall nearly 5 mbpd short within just 10 years. Did lightning strike the ruling family? Has the recent illness by King Fahd suddenly put the fear of mortality into the rest of the royal family? Whatever the reason for the admission their ocean of oil has sprung a leak, I am amazed the markets did not react to the statement.

Let's analyze the statement briefly. Maybe traders felt like a shortage ten years from now was not worth worrying about today? I have some bad news for everyone with that attitude. We are not just going to show up with a sudden 4.5 mbpd shortfall on July 1st, 2015. It does not happen that way. It will begin with a 100 Kbpd shortfall several years earlier then escalate to 200K, 300K, 500k, etc and grow into a real problem well before the 4.5 mbpd shortage in 2015. Once there is any REAL and permanent shortfall, even 100,000 bpd the prices are going through the roof as the bidding war escalates. Remember we are talking about 4.5 MILLION bbls per day, not just a blip here and there. Secondly and probably more importantly the admission of future shortages may be the first in a long series of admissions. Saudi production has been rumored to be in trouble for a couple years. The lack of any material jump in output over the last year has added fuel to those rumors. Consider the loss of face the Saudi family would suffer had they simply came out and said we have problems with our fields and we cannot increase production any further as previously stated. If you wanted to maintain face in the community wouldn't it be easier to start making admissions for the distant future and then slowly ratchet down expectations as time passes? American corporations do it all the time. Knowledge is power and doling out the bad news in "need to know" sound bites over an extended period of time keeps everyone in their comfort zone. The often-quoted image comes to mind of putting a frog in a pot of lukewarm water and turning up the heat slowly. The frog is lulled by the slowly warming water and fails to jump out until it is too late. I believe the admission by Saudi of a future shortage is the equivalent of turning up the heat on the global community a barely discernable notch. Continue to buy oil on the dips until the demand spike passes in Q4.

August Crude Chart - Daily

December Crude Chart - Daily

The rebound off the Thursday lows was astounding with the Dow gaining +250 into the Friday close at 10450. The Nasdaq closed at 2112 and the second best close for 2005. While the Dow close was only slightly above recent resistance at 10430 the Nasdaq sprinted above resistance at 2100 that has held numerous times since late January. The SPX rallied to close right in the recent resistance range between 1210-1215. It was a stellar end to a rocky week and while it clearly had the appearance of a short squeeze there was much for bulls to be excited about. The Wal-Mart earnings guidance started the ball rolling on Tuesday and there were other sporadic bits of good news to follow. However, the Wednesday decline on this good news appeared to be a continuation of the late June slump and bears were drooling at the opportunity ahead while loading up shorts for the summer. The Thursday morning terror bombing dip produced windfall profits for some and was probably seen as another tipping point to bring other shorts off the sidelines. The rebound clearly caught everyone off guard and the positive Jobs numbers added fuel to the short covering fire. I know many bulls will take offense to my description of the rally as short covering but the chart pattern is clearly covering in my opinion.

On Friday the economic news was decent, not outstanding and there were few positive events on the stock front. Alcoa was the only major company to post earnings but analysts were not impressed. The headline number at +54 cents was a company record although there was an 11 cents item that put earnings back in the 43-cent range analysts had expected. After earnings several analysts cut future expectations. AA jumped +$1 after the report. There was nothing in the Alcoa report that would have given the market wings.

Tech stocks did very well on Friday but it was not on the back of good tech news. Actually there were more warnings on Friday than there was good news. Three software companies warned, SEBL, BORL and ATRS. Chip stocks turned in a very strong performance despite a profit warning from NANO. Nanometrics said the up to -20% drop in revenues was a result of a general slowdown in the chip sector, which results in longer product cycles and delays in shipments. NANO dropped -11% but the SOX gained +10 points to 442 and within striking distance of the VERY strong resistance level at 450. For the week there were strong gains in chip stocks with INTC gaining +4%, ALTR +9%, XLNX +7.5%, NVLS +6.6% and KLAC +6%. These gains were on a week when it was announced Semiconductor Billings had fallen for the second consecutive month.

SOX Chart - Daily

IBM was a major impact on the Dow after several analysts posted positive comments now that their warning period has passed. IBM gained +4 since Wednesday morning and shorts were again forced to cover. There was a lot of speculation that IBM would warn after their poor performance in the last earnings cycle. When the warning didn't come the analysts were quick to jump on the crippled price in an effort to get their 15 min of fame. Merrill analyst, Steven Milunovich, said research suggests IBM has recovered from the missteps in Q1. He said expectations were so low that even a mediocre quarter might boost the stock. Laura Conigliaro from Goldman Sachs said bookings could exceed $12 billion and there may have been a rebound in hardware sales. Fulcrum Global's Robert Cihra said a solid enough quarter by IBM "could" boost investor sentiment. Gosh, all of those "qualified" comments really makes you want to buy IBM stock in hopes of a mediocre quarter. I doubt those comments provided our tech rally despite the +4 in IBM.

IBM Chart - Daily

The Friday rally or maybe I should say the week in general came on very light volume. The average volume for the week was only 3.7B per day. Friday's internals were very positive with advancing volume 5:1 across all markets with advancers beating decliners 2.5:1. Long time traders should realize that 2.5:1 A/D is hardly evidence of strong conviction. 4:1 or 5:1 is normally evidence of conviction. So what really powered this rally?

I believe we just saw the perfect storm where a variety of conditions all came together to provide the perfect short squeeze. First, we were severely oversold with a -475 Dow drop from the 10650 highs in late June. This provided cash for those who had lightened their positions over the last three weeks. Secondly, the late June dip gave traders the impression that the summer swoon was starting early and shorters backed up the truck. Thirdly, earnings warnings were running much stronger than normal and this increased the negative sentiment for stocks over the summer with a potentially weak Q2 reporting cycle. Fourth, weekly fund flows had been slow in late June and that reduced the amount of cash funds had available for vacation withdrawals. Add in the Russell rebalance on June 25th and there was a strong flow of cash out of stocks as June closed.

The combination of these events produced a severely oversold market at a time when fund contributions for the end of Q2 and the end of the first half normally hit accounts. Add in the late adjusters to the Russell rebalance and the positive bias to the Russell for the first 10 days of July and you have a strong underlying bid. Don't forget that next Friday is options expiration and all those bets must be covered. Institutions typically cover in the week before OpEx to avoid the various problems associated with cashing out or rolling over positions. Premiums for current month options die next week and those for the future months normally see a boost as retail traders scramble to roll over losing positions. Mix that together with a massive drop to Dow 10061 on the futures after the London terrorist attack and you got a perfect buying opportunity for those funds with new cash. Suddenly the shorts were caught flat-footed and looking the wrong way just as the armored car of cash came roaring around the corner. We all know how the story concluded as we have seen played out so many times over the years. Some shorts cover immediately providing the initial bounce. Others go into denial and a daylong torture event begins. As each round of shorts bites the bullet and covers it produces yet another step higher for the indexes and more pain for those still short. As the indexes rise inexorably higher more shorts from higher levels are dragged into the market as their profits erode and stops are hit. The TV commentators add insult to energy by replaying every positive sound bite they can find to justify the strong rally on suddenly good earnings prospects and benign economics. The final blow comes at the close when many traders are faced with taking the loss or be hit with a margin call on Monday. Oil also helped fuel the move with a drop from $62 to $59.50 and supplying a +70 bounce to the transports. For me this scenario provided the perfect storm for the bears and they were forced to close positions meticulously prepared over the last three weeks.

Now the stage is set for an encore performance on Monday. The surge in negative preannouncements has slowed and the ratios are starting to come back into the normal column. The dose of negative sentiment in late June has set us up for some positive surprises and the resultant spikes should they appear. Also, should Dennis turn out not to be a menace for the oil sector then oil could easily retest the $56 lows from June-30th or even the $54 lows from early June. It would only be temporary and while I would see it as a buying opportunity for oil stocks the drop should provide lift to the broader markets as well.

The challenge as I see it is not with market direction next week. I have said repeatedly I did not expect any further market drops until after next week. It is the first full week of earnings and option expiration week. The week I had targeted for a possible decline was the following week. However, last week I did suggest a potential short entry if the market rebounded to SPX 1210-1215. My targets for an index failure were Dow 10450, Nasdaq 2100 and 1220. I suggested an early entry in the 1210-1215 range just in case we did not hit that 1220 level. When the targets are as clear as 1220 we tend to see a lot of traders jump in early to avoid the rush. The results from this week surprised me. I did not expect to get there all in one day and I would not have expected it to happen after a new terrorist attack of that magnitude. Also we don't know how that attack will alter the summer trading pattern. The CIA had said recently that we would probably see a lot more 311 attacks (date of Madrid train bombing) than 911 attacks. It requires far less expense, preparation and loss of attacker lives to plant a few time bombs than engineer a major event like 911. The attackers in London all escaped safely and are free to attack again somewhere else. There was speculation on Friday that we could see an escalation of this type of attack as it is easier to recruit bombers than martyrs. The terms summer of terror and terror overhang were used in several conversations. How this will impact our normally weak period ahead is obviously unknown.

For next week my advice is still the same. Buy oil stocks on any dip and consider short positions on an SPX failure at 1220 or below. I am personally short from SPX 1212, 1216 on the futures. I believe the Friday rally was artificial and the event risk is on the side of the bulls. If I am wrong it will cost me a couple points and I will look for a higher entry. It is conceivable the Dow could return to strong resistance at 10650 but I would be very surprised. The SPX will have serious trouble getting over 1220. What causes me concern to the scenario I have laid out is the small caps and the Nasdaq. The break over Nasdaq 2100 is surprising this late in the summer cycle. 2116, only +5 points away is the 25% retracement of the entire bear market drop from the 2000 highs to the Oct-2002 lows. As such this should be strong resistance but 2100 had been strong resistance as well. The SOX rally to 442 was remarkable but 450 has been resistance since July 2004. Was it just short covering or simple optimism about 2006? The 2005 outlook has already been trashed for chips so it is not likely the reason.

Russell 2000 Chart - Weekly

The small caps are also giving me cause for concern and are acting very bullish for this time of year. The Russell closed at an all time historic high on Friday at 661. The S&P-Midcap also made a new historic high at 702. When the small caps are stampeding it is best to join them or stay out of the way. I do not know if this is still related to the Russell rebalance or they simply found new life with economics improving and funded by quarter end retirement contributions. These are the indexes to watch for market direction. If I am stopped out of my 1212 short on Monday I will not be reentering it until the small caps run out of steam. They represent true market sentiment. The bigcaps represent a place to store money in relative safety and make a marginal return. It does not take any guts for fund managers to hide money in Microsoft, PG, GE or similar lock boxes. It does take guts to put serious money into a small stock with a low float that could cost you a lot of money if you need to exit in a hurry. This is especially true if you do it with 100 different stocks. With the Russell in blue-sky territory a real rally here could easily hit 675. However, despite all this bullishness in the smallcaps we are still heading into the three weakest months of the year. The Aug-Oct calendar has been harsh to traders far more often than not. This is what I am basing my market view upon more than the current fundamentals. Even in good times the summer doldrums have sucked many a trader to their financial deaths more often than any pool of quicksand.

Heading into next week the end of quarter contributions should be over and short covering rarely lasts more than one day. Earnings reporting will accelerate sharply and we will get our first real insight into Q2 performance. The economic calendar is light until Thr/Fri when we get CPI, PPI, MAPI, MTIS, Industrial Production, Consumer Sentiment and a couple of manufacturing surveys. The stage is also set for an oil implosion/explosion depending on the final direction of Dennis. Once these acts play out we will have a really good clue for Q3 and the market will likely pick a direction. The rest of the summer earnings cycle will be a footnote to the headlines. Choose your positions well as we navigate through the coming doldrums, enter passively and exit aggressively if you are wrong.

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