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Oil Creeps Higher, Stocks Wilt

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Oil Creeps Higher, Stocks Wilt

Oil prices have almost completely recovered from their July swoon and broke the $61 level once again on Friday. Stocks, tired from a breakout to new highs took the day off for a well-deserved rest. The major indexes gave the appearance of a rally but closed flat for the week. The earnings parade is drawing to a close and the high volume on Wed/Thr faded as traders eager for a weekend break closed their books early.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The economic news on Friday was good across the board and there was plenty of it. The headline news item was Q2 GDP at +3.4%. This was slightly below the consensus of +3.5 and below the +3.8% level for Q1 but still well within a satisfactory range. A drop in inventory investment by -$6.4 billion was responsible for the slower growth. Consumer spending rose +3.3% and business cap-ex spending rose by +9%. The bad news was a jump in inflation with the personal consumption expenditures (PCE) up +3.3%, one point higher than Q1. The core PCE was up only +1.8% and rising at a slightly slower rate than in Q1. Higher energy prices were the main reason for the jump in the PCE. The Fed watches the PCE closely for signs of inflation and this release suggests there will be a continued series of rate hikes into 2006. Greenspan's testimony last week also confirmed this assumption. There is no end in sight for hikes at this time although a Fed rate of 4.50% is now the target number by analysts.

The Employment Cost Index showed employer costs rose +0.7% in Q2, which is no surprise to any employer. Health care costs continue to rise and the higher cost of employee expenses is being passed on to employees in the form of lower wages. Wage growth over the last couple years has been exceptionally weak and that is helping to keep a lid on inflationary pressures. Benefit costs rose +0.8% in Q2 but to a level that is +5.1% over Q2-2004. A +5% gain in only one year is very strong. This will continue to pressure jobs as employers try to contain costs. Employees can expect to work more and get paid less as the ranks are continually pared to the minimum number of employees possible to get the job done.

Consumer Sentiment showed no decline in the final numbers for July as the closing update showed the same 96.5% as the initial reading. The softening of gasoline prices over the summer vacation period acted to ease sticker shock with each fill-up. The expectations component rose slightly as consumers looked ahead to fall.

The NY-NAPM rose to 339.6 ending two months of decline. The July reading almost erased those two declines and came close to the 341.2 high set in April. July's number was the second higher reading for 2005. Business conditions in New York appeared to have weathered the spring soft spot and a rebound is underway. However the outlook component fell to neutral meaning there is little visibility for future conditions.

The July Chicago PMI surged to 63.5 from its 53.6 reading in June and well over consensus estimates of only 55. This reading erased the prior two months of declines and returned it to near its cycle highs. A +10 point jump in this is indicator is very strong. Internal components surged with New Orders jumping from 56.5 to 69.6, Order Backlogs from 45.3 from 56.1 and production from 57.8 to 70.5. The jump in orders and order backlogs suggests an acceleration in business conditions that should carry over into future months. Again, the spring soft patch across the country appears to have passed.

This flurry of strong economic news produced a mixed open on Friday with the good news mixing with some weak earnings and guidance. The early morning spike eroded into a session of profit taking as the day progressed. Given the week behind us that profit taking was completely justified. The weekend headlines will carry only good news with the Dow up +4.1% for the month making it the best showing since December 2004. When you reflect on how range bound the Dow has been for most of the month you realize the majority of the gains came in only two days starting on July 7th followed by a huge gap open on the 14th. Those three days accounted for nearly +450 points of Dow gains leaving the rest of the month as a range bound consolidation period. The constant bumping against the top of the range finally managed to produce a break over 10700 on end of month buying and that prompted at least a few bulls to throw in the towel. The Dow declined -64 points on Friday to close at 10643.

The Nasdaq headline will be even more impressive with a +6.3% gain for the month and the best month since December 2003. The Nasdaq road map looks a lot like the Dow with big gains on the same three days but adds another one on the 19th that broke it out of the prior consolidation and into another range. End of month buying pushed the Nasdaq out of that higher range to tag 2200 on Friday and ringing the exit bell. The Nasdaq closed at 2185 for a loss of -12.

The SPX also broke out of its boring upward bias to tag the next level of uptrend resistance at 1245 the same time the Dow and Nasdaq were touching 10700/2200. Amazing how those round numbers coincide. When Friday's smoke cleared the SPX had returned to the 1233 range where it had spent most of the week. While I was beginning to think the breakout had legs I want to see what happens after the month end buying before switching to a bullish bias. The drop to close at 1233 could be just profit taking and next week will be key for eventual market direction.

SPX Chart - 30 min

The SOX failed to move higher for the week but it also failed to give up any ground on Friday. The SOX has clung to 475 like a drowning man to a life raft. The conflicting chip earnings and guidance has come and gone but for eight straight days the SOX has failed to stray far from that 475 level. It still faces very strong resistance at 485-490 and this could be consolidation ahead of a breakout attempt or an indication that traders do not have enough conviction to overcome the summer doldrums ahead.

The Russell is still possessed by a bullish spirit and refuses to roll over. The constant series of new highs was blunted only slightly by a -3 point dip on Friday. The uptrend appears poised to continue with this weeks 685 high only a stepping-stone higher. At least this is what the chart appears to be saying. A contrary viewpoint would be an oversold index due for a rest. The closest support is 675 followed by 667 and 660. The breakout by the Russell is the most bullish confirmation a market could ask for. However, the Russell has help with the transports also confirming.

Russell Chart - Daily

SOX Chart - Weekly

SOX Chart - 60 min

Dow Transports Chart - Weekly

The transports have rallied from a quadruple bottom low at 3400 to just over 3800 for a +9% gain in only a month and in the face of $60 oil. They fell slightly on Friday as oil hit $61 intraday but only slightly. The transport rally has been confirming the move in the broader markets and a breakout over 3800, the prior all time resistance high in 1999, and a break over the current all time high at 3889 set back in March, would be very bullish. This makes the initial resistance at 3800 especially critical to hold for the next week.

With more than 65% of the S&P reported we are seeing Q2 earnings at the high end of estimates, thanks to the outstanding energy profits, and Q3 guidance has improved to inline with estimates at +16% growth. Without the energy stocks the performance and outlook would have been substantially different. Energy earnings have been from outstanding in the +30% to +50% range to over +100% in some cases. This went a long way on improving the S&P earnings and outlook. Energy stocks should continue to rise with oil futures hitting $61 intraday on the current contract and $63 on the December contract. However, oil stocks fell on profit taking as earnings traders took profits and moved on to other trades. Oil demand estimates are beginning to creep upward again and the stage is set for a Q3 rally into the heating oil season. Continue to buy the dip until we see a change in outlook.

December Crude Oil Chart - Daily

In oil news there were three fires at different installations that helped trigger the move higher on production concerns. Unocal posted a +40% jump in earnings and that fueled increased speculation that CNOOC would make another bid to buy the company. A Chinese newspaper claimed CNOOC was preparing to make another bid that could come as early as next week. However, an unnamed CNOOC official said Unocal was no longer a takeover target due to potential U.S. government intervention. Meanwhile the Financial Times reported late Friday that CNOOC was considering a $20 billion "knock-out" bid to be made public just prior to the August 10th Unocal shareholder vote. Chevron is not sitting idly by and said the Unocal earnings made the company even more valuable to Chevron. You think they are saying that just to make CNOOC think they will rebut any higher bid? I would bet on it and the fact remains Chevron NEEDS to acquire Unocal. Chevron recently reported that their proven reserves fell -11% in 2004 as oil becomes harder and more expensive to find. Chevron said financial projections of the merged company were much stronger than originally stated due to positive events at Unocal. Chevron has offered $17B for Unocal and CNOOC bid $18.5B. CNOOC has almost no chance of getting its deal approved by the administration and may want to save face by withdrawing instead of being blocked. Friday the Senate voted to approve the $14.5 billion energy bill which has a provision attached to block the CNOOC/UCL deal pending a four-month review. It was widely expected that CNOOC would not make any further moves until lawmakers recessed for the summer to avoid any further knee jerk reactions by lawmakers prior to the August 10th shareholder vote.

On a day where stock news was overshadowed by the urge to leave early for the weekend those investors in Whole Foods were rewarded with a weekend treat. WFMI announced earnings that increased +31%, beat the street by +3 cents and raised guidance. This was a pure case of weakened expectations and a high short interest being hit with the glaring light of a contrary reality. WFMI shares jumped +14 to 136.50 as shorts were not just squeezed but battered badly. Analysts had been downgrading WFMI and the stock had been listless in a tight trading range for the last quarter. Investors who kept the faith were well rewarded. After a +14 point jump +10 points over their prior all time high I would think puts would be in order.

With the weekend headlines set to show a bullish July it would appear to retail investors that they are missing the train. They might not be the only ones with commitment issues. There are a group of traders including me that question this non-stop rally ahead of the historical August dip. There is another group holding off on longs in fear of the decade low on the VIX, another historical danger sign. There are other traders, including a large number of institutions, who typically wait for the Sept/Oct dip to enter positions. They are probably watching the new highs with a great deal of worry that they too are missing the train. The bears, fully aware of all those points have been continually shorting each progressive high only to be forced to cover time and time again. One reader email this week questioned the contrary trend and wondered if it could continue. Yes, is the short answer. As long as nearly everybody expects the markets to pause in August there is always the chance we will move higher. The more traders who believe a drop is coming the more traders will be short. With each dip being bought by those thinking the train is leaving the station and buy programs far outnumbering sell programs the shorts will continue to be squeezed. The problem comes when everyone decides we are going higher and the shorts give up the game. Without the shorts to provide the motive power the market sentiment could change. I know it sounds crazy that once everyone turns bullish we could get a market drop but it does happen. It takes both sides to make a market.

The earnings parade is coming to a close but we will continue to get a slowing trickle of earnings headlined by Dell (8/11) and Cisco (8/9). Earnings over the last two weeks has provided lift to the market on the surface. If you look at the market stats header above you may be surprised. Last week the Dow lost -10, SPX -1. The Nasdaq only gained +5, Russell +2 and the broadest index of all the Wilshire 5000 only added +23. BUT the perception by retail traders, the talking heads on TV and the newspaper headlines this weekend will be that the markets are in rally mode. Does the knowledge that the indexes basically finished flat for the week change your perception of the market?

I believe we should continue to be cautious over SPX 1225 until the market provides confirmation in the form of volume and points. Yes, we touched new highs but promptly gave them up along with all the gains for the week. Not much confirmation there. Volume on Friday was the second lowest in the last two weeks. BUT, that was the good news. Weak volume on a down day is a market positive and it was a summer Friday. The damage could have been a lot worse. The internals were also bullish despite the headline numbers on the indexes. The 52-week highs for the last two days have been very strong averaging over 700 per day. This is well over the numbers posted since the July 11th spike at 868. We have seen numbers well under 500 and as low as 217 over the last three weeks. I view this as bullish confirmation of an underlying bid. HOWEVER, it could also have been due to month end buying by institutions and funds.

While I am leaning more bullish as each day passes I am still watching for lightning to strike. Like playing golf on a cloudy day you could be having an awesome round but are constantly watching for signs of lightning to cancel the game. The markets struggled higher during the week with improving internals but we don't know how much of that was artificial due to month end buying. On Monday we begin the back nine, using the golf analogy, and the storm clouds are still gathering on the horizon. Just like a very hot summer day tends to produce monster storms a very hot market next week could do the same. I know the minute I turn completely bullish the market will turn on me in a heartbeat. So I will continue to recommend cautious longs over SPX 1225 and shorts only below that level. The bottom of the Dow range is just under 10600 so a move below that level would be a danger signal. The Nasdaq is much stronger with support at 2165 and 2145 before falling out of its range.

Storm clouds looming next week include the ISM on Monday, Factory Orders on Tuesday and Nonfarm Payrolls on Friday. The ISM is expected to rise based on the improving regional reports we have seen over the last few weeks. This should be market positive unless it is a blowout over the estimate of 55, which would be Fed negative. The Jobs report is expected to show a gain of +175,000 jobs and a stronger than expected gain there would also be Fed negative. There is a growing whisper suggesting the Fed will remove the measured pace language at the August 9th meeting in preparation for a 50 point move in September. All signs point to an accelerating economy and the Fed will want to be ready to step up its pace of rate hikes. This makes the ISM and Jobs reports this week all the more important. Critical inflection points while the market struggles at its highs only add to the danger of a change in market sentiment. With the current Fed Funds rate at 3.25% it is very tolerable to stocks. Should the Fed escalate the rate hike process we could be over 4% very quickly and numbers over 4% typically begins to pressure stocks. There were several economic analysts interviewed on Friday regarding the GDP and two mentioned the potential for a 5.+ number for Q3. If they are thinking the economy is picking up speed that fast then the Fed is also thinking it and planning ahead to slow it down. This makes these two reports and the Fed meeting only a week away a potential roadblock for the markets. Either report could be that lightning bolt that ends the game. As long as you are expecting the worst it is easy to plan for future. Keep those stops tight, enter passively and exit aggressively if lightning does strike.


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