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New Highs, Now What?

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New Highs, Now What?

Bullishness was breaking out all over for most of the week. The Nasdaq closed at 2157 and a new high for 2005. The SPX closed at a new four year high at 1227 to cap seven straight days of gains. The Dow closed at a four month high at 10640 and had the best run since the elections. The SOX sprinted to a new 52-week high at 463 and well over resistance. The VXN closed at a new historic low at 13.32 and the VIX closed at 10.33 and levels not seen since 1995. The VXO (old VIX) dipped to 9.80 intraday and closed at 10.04 also a level not seen in over ten years. All the markets at new highs and the volatility indexes at new lows. What is wrong with this picture?

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

So many factors, so little space. The markets rallied on positive economic news according to the talking heads on TV. I agree the news has definitely turned strongly positive but I have a hard time believing it powered the markets to these levels. If economics are so strong then the Fed is far from done and traders seem to be forgetting that factor. Instead of a 4% top rate we could see 5% or more if the economics continue to improve sharply.

Headlining the economic reports on Friday was the PPI, which came in unchanged and well below the +0.4% consensus. Prices failed to rise despite a +2% jump in energy prices for the period. Crude goods prices actually fell -3.3%. The core rate actually fell -0.1% with intermediate goods rising only +0.1%. Crude materials like iron and scrap steel fell -19.9% and cotton fell -13.7%. If prices are not rising despite higher energy costs it definitely shows inflation is almost non-existent. Competition in a slow economy is driving the prices down and while this is Fed friendly it could be trouble if it continues. Price pressures eventually pressure profits.

On the flip side the Industrial Production number soared by +0.9% and three times the consensus estimates and the headline number for the prior month. Again the headline number is not to be trusted with +0.5% of that number being an increase in output by utilities companies. Manufacturing output, a better gauge of economic health still rose a robust +0.4% and more than the consensus for the overall headline number. Capacity utilization rose to 80% and the first time in this cycle to reach that high. This is the highest level since Dec-2000 but still a point below the 1972-2004 average and two points below the 82% average for most of the 1990s. This is a very strong report BUT it suggests the economy will be at full capacity within the next year and that could lead to higher inflation pressures. When there is no slack in production, manufacturers can command higher prices for products.

Business Inventories increased only +0.1% and it was the smallest gain in 16 months. This marks a continued decline from the 0.9% growth in January. This is a May number and as such carries little weight with the current market and was influenced strongly by the growing auto inventory levels at the time. June's report should be substantially different.

The NY-Empire State manufacturing Survey soared to 23.9 compared to June's 10.5 level and a minus -11.1 in May. It appears the soft spot is over in NY and they are gaining traction quickly. The headline number was well above the 10.0 consensus. New orders, shipments and backorders all rose sharply. Shipments for example jumped to 20.9 from only 1.0 in the prior month. The six-month outlook jumped from 34.0 to 47.0.

July Consumer Sentiment came in at 96.5 and almost flat with June's 96.0 and right inline with consensus estimates. Consumers seem to believe that the jobs market is improving and they are becoming immune to the higher gasoline prices. The recent market rally also contributed to the sentiment levels.

Friday the Dow was impacted by three story stocks. GE reported earnings that were inline with estimates but Q3 guidance was less than analysts had expected. All eleven divisions grew at double-digit levels and CEO Jeffery Immelt was very upbeat about the U.S. economy. Still the stock was under pressure most of the day due to the Q3 guidance.

McDonald's raised its Q2 guidance to 51 cents after a charge and that was three cents better than analysts expected. MCD reports next week. The company reported that same store sales trends were up +5.4% in the U.S. and profits were bolstered by strong sales in Germany and France. MCD jumped +1.39 to $31 and a six-week high.

The biggest news was probably from HPQ. The company said it was about to slash 15,000 jobs on Monday and could cut another 5,000 before its coming earnings report in August. HPQ said it could save $1.5 billion from the cuts. HPQ closed near $25 and a new 52-week high.

With the Dow hostage to the story stocks and trading at four-month highs at 10650 there was little excitement to power it higher. The Dow gained only +11 points and spent most of the day in negative territory. Only three Dow stocks posted changes greater than 50 cents. Those were all gains from MCD, AIG and HD with MCD the only change over a buck. It was not an exciting day despite the close at a new four-month high.

The SOX closed nearly unchanged despite a major hit to Rambus of -7% that pushed it back to $13.50 support. RMBS reported earnings that were lower than last year and did not please the street. They also said future guidance would be difficult due to the various court battles and negotiations in progress.

Electronic Arts (ERTS) was also crushed after saying it would delay the release of its Godfather video game. The company now expects to miss the early holiday season with a release tentatively slated for the fourth quarter.

Much of Friday was spent rehashing the HPQ/GE news and the new initiative to stop the CNOOC/Unocal deal. Senator Byron Dorgan mounted a new attempt on Friday to block the deal on the basis of national security. There are separate attempts in both the house and the senate to block the deal by various means. As the opposition builds the price of UCL shares dropped a buck from their highs at $66.79 on Thursday. The board is reportedly reviewing the CNOOC offer but continues to delay their recommendation as the outside battle swirls around them. I continue to expect Chevron to raise its bid as we draw closer to the August 10th shareholder vote. This is pressuring the price of Chevron's shares, which closed at $56.60. Should Chevron get the nod on August 10th I expect a significant rebound in CVX stock since it currently trades at a strong discount to the market as the battle rages. Given the current opposition over the CNOOC bid it would be beneficial to everyone if Chevron raised its price and eliminated the pressure from the board. The board could then rubber-stamp the deal and coast into the vote only three weeks away. The government would not have to block the acquisition and make China angry at a time when they are trying to work out the Yuan revaluation.

In an unrelated event a Major General in China's Peoples Liberation Army, Zhu Chenghu, said China was prepared to use nuclear weapons against the U.S. if the U.S. interfered in any Taiwan conflict. He said China will prepare itself for the destruction of all cities east of Xian but the U.S. will have to be prepared to lose hundreds of cities as well. OK, is there any question why we need to block the Unocal acquisition? Giving any communist country talking about waging war against you the strategic resources to fuel their war machine is really dumb. Representative Jim Saxon on Thursday said war with China was inevitable and likely by 2014. According to several international think tanks China appears to be readying its forces to wage war with the only superpower left, the U.S., over oil. Unbelievable, I have been saying it for months and I see others are coming to the same conclusion. http://www.indiadaily.com/editorial/3598.asp

Other articles show how China is applying pressure to its neighbors who are friendly to the U.S. For instance Unocal is a small player in the U.S. energy market but it is a big supplier of natural gas in Southeast Asia. Its pipelines run through several Asian republics friendly to the U.S. If China gained control of those pipelines it could threaten to cut off critical gas supplies to those countries if they did not drop relations with the U.S. This would give China a wider buffer zone around its borders and eliminate potential bases for U.S. attacks. This is already happening according to General Richard Myers, Chairman of the Joint Chiefs of Staff. He said last week that Russia and China, (remember I told you they signed a joint declaration of mutual support against the U.S.), were applying pressure to countries in their sphere of influence. They are pressuring countries that currently allow the U.S. to host forces in the war on terrorism or maintain stop off bases. The statement last week by the Shanghai Cooperation Organization was interpreted by some as an attempt by Russia and China to push the U.S. out of a region that Moscow regards as historically part of its sphere of influence and in which Beijing seeks a bigger role because of the region's extensive energy resources. That is enough of my soapbox ranting for this week but you get the picture.

Hurricane Emily turned towards the South American coast and oil platforms in the Gulf breathed a sigh of relief. Oil prices fell to support at $58 and traders took profits on the recent oil run. This gave anybody interested another buying opportunity as the season progresses. There will be more hurricanes and more disruptions from other reasons before the fall demand season appears. Next week we will get the inventory levels from the Dennis shut in and they should be bullish for prices once again. Time is counting down to the switch over to heating oil and that is when the trouble is really going to start. Continue to buy the dips until the picture changes. This would be an excellent chance to buy the BP Oil Trust (BPT) to qualify for the next dividend payment in October. The trust is currently paying nearly 10% per year plus stock appreciation. July 13th was the ex-dividend date ($1.728) for Q2 and the stock dropped -$5 on the ex-dividend and the drop in oil prices. It was up +$20 since the April ex-dividend drop so a -$5 ex-dividend drop this week was not a problem.

Natural gas spiked over $8 in the current contract but has been bouncing off $9 in the December contract. Current gas prices are slightly over $7 and the December chart indicates heating this winter is going to be expensive regardless of your energy source.

December Crude Chart - Daily

December Natural Gas Chart - Daily

The rally appeared to be running out of steam as the weekend drew to a close. The only volume increasing was option volume as expiration Friday extracted its pound of flesh from those on the wrong side of their trades. I believe that much of the rally was due to this option expiration cycle and many traders being caught leaning the wrong way. Market breadth declined substantially with advancers barely edging out advancers 3582 to 3455. A/D volume was almost dead even but the real news was in the new highs. After a spectacular start to the week with 868 new highs on Monday and 695 on Tuesday those numbers declined the rest of the week to end with only 216 new highs on Friday. Ironically it was on Friday that the indexes eked out further marginal gains to new highs. It was an option expiration gasp at the close that pulled the indexes out of negative territory and sent the VIX/VXO/VXN to decade lows. I alluded to this in the opening paragraph as something being wrong with this picture. Very wrong!

VIX Chart - Monthly

VXN Chart - Weekly

VXO (Old VIX) Chart - Weekly

Historically the combination of new highs on the market indexes and extreme lows on the volatility indexes spelled danger. The fact that this occurred on an expiration Friday in July is even more critical. Add in slowing volume, barely positive market breadth and a monster rally over the last two weeks and you have a recipe for disaster. Don't get me wrong. I would love to see a bull market all the way to January but the odds of that happening are exceedingly slim without at least a couple corrections in the process. It would also be nice if we could plan those corrections and have them appear only when all the signs aligned and everybody was ready to take profits and shift into different positions. Unfortunately nobody can ever tell us exactly when the next correction will occur. Even having all the factors I mentioned above in perfect alignment does not guarantee a sudden fall from grace. All we know is that there is a certain point n our future when the major players will decide they are done buying and push the sell button instead of buy and the drop will begin.

Just like breaking out or closing at a new high will not guarantee a continued rally as technicians might have you believe the pause and apparent failure at those highs will not guarantee a correction. However, the question most asked on Friday was "should we buy the top?" That top was represented by the SPX at 1225 and a four-year resistance high. The Dow was at 10650 and also a four-month high. Those types of resistance highs tend to attract selling even when the other factors don't contribute. The other factors are the extremely low volatility, decreasing volume and narrowing breadth after a two-week rally. That makes this resistance top especially critical. Add in the approaching August-October doldrums and it appears as almost a perfect storm for the bulls.

The bulls might argue that earnings shift into full swing next week and nearly all the heavy weights will take their turn at bat. The bears would claim that the rally over the last two weeks has already priced good earnings into the market and we are setup to fail. Zacks has predicted that Q2 earnings will come in at 12% growth. This is slightly higher than estimates from S&P and First Call just two weeks ago. The earnings this week have been mixed with high profile winners and losers but no shining stars. As always at this point the bulls want to know what you are going to do for us in Q3 and Q4 rather than Q2. Just don't tell us you tripped in Q2 or it is a haircut for your stock price. Guidance next week is going to be the key and GE started it on Friday with lower than expected Q3 estimates. Will that carry forward to the other reporters? Is there going to be a group letdown for Q3? Will the chip sector move higher after a +45 point gain in the SOX in only two weeks? The calendar is packed full for next week with nearly all the majors reporting. Monday leads off with MMM and IBM. On Tuesday we will see INTC, YHOO, NVLS, AMGN and about 150 others. Wednesday has EBAY, QCOM, MO, UTX and about 200 more. Thursday is headlined by MSFT, GOOG, MRK and over 250 others. By Friday's close over 750 companies will have announced earnings for the week and there will be no further mystery. We will know what the final earnings projections are and the complete guidance picture for Q3. In short despite a thousand more companies to report over the next few weeks the Q2 earnings story will be over except for a few footnotes to follow as CSCO, HPQ and Dell close out the cycle in early August.

I think market direction will also be established before the Friday close. Despite the SPX close at 1227 on Friday that 1225 resistance we have been watching still has a firm grip. Every spike over that level is quickly sold and 1225 returns. I continue to see 1225 as our line in the sand. I continue to believe that we should remain short below that level and cautiously long if we do finally make a break over that threshold.

The Dow has rebounded back to challenge the 10650 high from June and from late March. There is a huge void over that level should a breakout occur and 10875 becomes the next resistance battle. The 10650 level should be substantial resistance but not insurmountable if the rally is real. The Nasdaq has been acting like it was possessed given the dual support of the SOX and the Russell. The Nasdaq closed just under 2160 and only 30 points from a new 2005 high and a level not seen since June-2001. If that 2191 level can be broken the next real resistance is not until 2250 and a level most traders never expected to see until late 2005. Supporting the Nasdaq is the SOX and its recent spike is even more pronounced than the Nasdaq's. The SOX has rallied +45 points from the July lows and is only 35 points away from a 25% retracement of the entire bear market drop at 495. Significant resistance awaits at that 490-500 level and without some kind of catalyst I can't comprehend a break through that level until Q4. Personally I could not comprehend a break over 450 without any bullish signs in the chip fundamentals but it happened anyway. All indications of chip activity are still weak including orders and billings and shipments are still being delayed. We will get the Semi book-to-bill next Tuesday after the close but the index has already priced in a monster improvement.

SOX Chart - Daily

Russell Chart - Daily

Also supporting the Nasdaq is the Russell, which broke out to a new all time high on Monday at 672 and followed it up with another punch to 674 on Tuesday. This remarkable performance was a continuation of a rally dating back to the April lows at 570. A +100 point, +17% gain off those lows. The Russell experienced four bouts of selling in that run with the latest the week of the Russell rebalance. Since the London terror dip it has been vertical until Tuesday's near touch of 675. Weakness has appeared and were it not for what I believe was expiration pressure at Friday's close it could have ended much lower.

The weakness in the Russell ahead of the late summer doldrums could be the first crack in the Nasdaq foundation. The Russell rallied out of its rebalance dip on late buying by the index funds and may now be running out of steam. The SOX rallied on what I am assuming is Q2 earnings expectations and the hope of some positive guidance from the chip companies when they report. That leaves us with both supporting pillars for the Nasdaq in shaky territory. They could quickly firm up again should the earnings and guidance be miraculous but that may be too much to wish for.

My commentary for the last two weeks mentioned that I was looking for next week to be a turning point in the market. I picked next week as post expiration and the telling point for earnings. Once we see how the majority of earnings and guidance is going to play out I believe funds are going to position themselves for an Aug-Oct buying opportunity. A trader with Pacific Crest Securities said late Thursday he was already seeing funds begin to lighten up and hedge funds were positioning themselves to get short. This is exactly what I am expecting. The funds had to get past options expiration before they could make a position change. Now they are hoping for some strong earnings to provide one last boost of volume to allow them to exit unwanted longs gracefully and start getting ready to buy the Aug-Oct dip. It is mid July, the beaches are calling and the vacation schedule is compressing into the six remaining weeks of summer. Traders thoughts are less on trading and more on time off.

I went back and researched the summer lows on the Dow and Nasdaq for the last ten years. Unless there was a major earnings miss that dumped the indexes during the July earnings the summer low normally occurred in the first two weeks of August. That dip was normally bought with a bounce into September. Since 1997 and not counting 2001 there was a lower low in Sept/Oct six times with five of those lows in October. 2003 was the only exception where the August low was lower than the Sept/Oct low. In 2001 we were already heading south at a high rate of speed before 9/11 interrupted the markets. 9/10 was already a five month low before the attack. That makes it seven out of eight years where there was a lower low after the August dip. To carry that one step further all eight years saw an August dip. Granted, history does not have to repeat itself but the odds are in favor of the bears at this point. The only questions are "from what level will that August dip occur" and "when will it occur"? Baring any major earnings miss to kick us off the ledge I would lean toward a high being set next week and a dip beginning soon. The Fed meets again on Aug-9th only three weeks away. If the economic indicators continue to move higher then there could be some fear that the Fed would change its language to allow a bigger move at the September 20th meeting. Instead of reading tealeaves or getting my bias from CNBC I am going to continue to watch 1225 for a signal of market direction. I plan on remaining short below 1225 and cautiously long over that level. I am buying oil on the dips and that gives me something to do until the broader market either breaks out or down. Enter passively and exit aggressively if the market goes against you.


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