Option Investor
Market Wrap

Porridge Too Hot

HAVING TROUBLE PRINTING?
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The Goldilocks economy burned its tongue on Friday on a hearty serving of hot jobs. The not too hot, not too cold economy found itself sweating after the Jobs report showed a jobs gain of +207,000 in July. Suddenly the looming Fed meeting next Tuesday took on an accelerated risk and traders decided to take profits.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The big headline for Friday was the Jobs report blowout and every mention carried the Fed meeting footnote. Jobs for July surged +207,000 and well over the consensus estimate of +180,000. The numbers for May and June were also revised upward by +42,000. The unemployment rate remained stuck at 5.0% mostly due to many workers dropping out of the job market rather than getting new jobs. While this appears to be a strong report based on the headline number there are some problems under the hood. You know I rarely take the headline numbers of any report at face value. The Bureau of Labor Statistics periodically adjusts the real survey numbers based on historical/seasonal trends. For July nearly 100% of the gains were the result of a seasonal adjustment. While the impact of the headline number was an immediate knee jerk reaction the reality of the report was much less severe. The second problem area was the +0.4% jump in hourly earnings. This sharp increase suggests wage inflation may be starting to creep into the economy. Wage inflation feeds price inflation and this is one more reason to worry about the Fed meeting next Tuesday.

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The strong Jobs report sent expectations of Fed hikes another notch higher with the odds for a removal of the measured pace language jumping strongly. Analysts are mixed over the expected ending point for the hikes with the range from 4% to 4.5% with the 4.5% camp gaining followers. One point everyone should remember is that Greenspan will be retiring in January. Nearly everyone expects the Fed to halt its hikes before he retires. This will leave the new Fed head a neutral Fed prepared for any future crisis. The current front-runner for the position is Ben Bernanke. That suggests the Fed may accelerate its rate hikes to meet its neutral ceiling by January. There are four meetings remaining in 2005, Aug, Sep, Nov, Dec. If the Fed is going to target 4.5% then one of those meetings will have to be +50 points. If the economy is really accelerating as fast as it seems with a +5% Q3/Q4 GDP as many suggest then the Fed may want to target something in the 5% range instead. That would setup a race against the clock for those remaining four meeting. Never go to 5% you say? Remember also that the Fed historically always goes too far when they enter a hike cycle and that better than 75% of hike cycles end in a recession. The ECRI Future Inflation Gauge also released today jumped +1.3% for the second consecutive month of increases. Other FIGs from around the globe also showed a jump in inflation risk. Energy prices are the primary driver. The Euro-zone jumped to a 51 month high at 99.9, still below the U.S. at 119.0 but the trend is clearly in place. This is yet another reason for the Fed to remove the measured pace restriction.

Despite the headline Jobs numbers and the jump in hourly wages the American consumer is still being squeezed. In the Personal Income report earlier this week it showed that the savings rate had fallen to zero and the second lowest level since the great depression. With interest rates rising and energy prices soaring the minor +0.4% jump in hourly wages is like finding a penny on the parking lot. It is hardly worth the effort to stoop over and pick it up. If the Fed does accelerate its rate hikes we are coming dangerously close to a real economic meltdown. Hopefully they understand this and will stop early for once.

The sticker shock over the Jobs report sent bonds over the cliff dragging the stock market behind it. There was one real standout and that was Baidu (BIDU). This small Chinese Internet stock hopes to be the Google of China. It IPOed on Friday at $27 and soared to $150 intraday with a close at $123. This was a +350% gain making it the most successful IPO in years. The relatively small float of only four million shares changed hands many times with volume on Friday of over 22 million shares. On the surface it would seem every share was traded five times but analysts claim over two million shares were held by institutions and not traded. This means the other two million were traded over ten times each. Those trying to short the initial open to $65 were squeezed for every penny as it became impossible to find shares to cover. Since the company only has $30 million in sales and $12 million in cash flow the instant jump to $4.4 billion in market cap is not likely to last. Venture capitalists own 45% of the company and are currently in lock up. Founder and CEO Robin Li owns 22.4%.

Delphi started a bonfire with a draw down of $1.5 billion of a $1.8 billion line of credit only a couple days before it is to file its 10Q. Normally this would not be a problem except that Delphi has covenants allowing it to use the credit line only as long as certain conditions are met. The 10Q is expected to show a violation of those conditions and void the credit line. By making the draw down just before what is expected to be an ugly 10Q the company could be trying to hoard liquidity ahead of a bankruptcy. All the credit agencies cut Delphi's debt and the bankruptcy watch is on. Delphi may be loading up on cash to strengthen its hand as it negotiates with GM and the unions in an effort to avoid bankruptcy. A Delphi bankruptcy could put an additional $9 billion pension liability back on GM so you can bet GM will be pulling strings to keep its 1999 spin-off afloat. DPH lost -15% on the news and GM accelerated its four-day dive. It appears the news leaked out early given the sudden drop in GM on Tuesday.

September Crude Oil - Daily

December Natural Gas - Daily

Oil closed at another new high at $62.31 after touching $62.50 intraday. December Natural Gas closed at $9.61 and a strong new high with $10 not far away. Over the past week seven refineries with total capacity of 1.7 mbpd experienced unplanned shutdowns. This was 10% of U.S. refining capacity and gasoline stocks fell by -4 million bbls stretching the decline to five weeks. It is almost a sure thing that $70 oil (sweet crude) is right around the corner. The Iranian Deputy Minister quoted that number this week when he said OPEC has no spare capacity. The problem continues to be not only oil production but an increasing dependence on refining capacity. TSO said this week that its refineries have been running at 100% capacity and that echoes the same types of comments from all the major refiners. There is not enough refining capacity to allow the refiners down time for repairs and upgrades. As a result we are seeing outages from equipment failures, many resulting in fires that are impacting not only the price of gasoline but the supply. September gasoline futures closed at $1.83 and only -3 cents from its record high last month. With only a few refiners capable of processing the excess sour crude from OPEC the increasingly tighter supplies of sweet crude are in even higher demand. Oil stocks were hit with the same profit taking hitting the broader markets but a break of oil over $62.50 next week should give them new life. There is a new depression in the Gulf, which will be called Irene if it turns into a hurricane. Historically we are just moving into the strongest period for storms Aug-Sept and the predictions are for 7-11 more hurricanes this year. The odds are very good that one of them will do substantial damage to the oil sector. It is simply the law of averages. Continue to buy the dips until the trend changes.

Rumors are flying that Microsoft is going to announce another huge dividend and that has powered the stock to a new three-year high in only five days. Microsoft has been seen as dead money for several years and has been locked in a $22-$27 trading range. Last Friday MSFT closed at $25.59 and right in the middle of its range. This Friday MSFT came within six cents of $28 and closed at $27.77. This may not seem like a lot when compared to the daily moves in the oil sector but with nearly 11 billion shares outstanding that represents an increase in market cap of nearly $24 BILLION. I guarantee that is far more than they will pay out in a dividend and anyone holding Microsoft should raise their stops quickly. As we have seen so many times in the past, the ramp on expectations of good news is normally stronger than the actual news.

Microsoft Chart - Weekly

The market exists to confound the most traders at any given time. This week was a definite example. For nearly two months I cautioned that we could see a market turning point in the week ended July 22nd. The Dow top occurred on the 29th instead of the 22nd with the other major indexes following a couple days later. The SPX hit a four-year intraday high of 1245.15 on the 28th and repeated that top four days later. What frustrates me more than missing the turning point by a week was my reaction to the Tuesday action this week. I reported that we finally saw a confirmation day with decent volume and great internals. New highs hit 738 on strong volume. I was almost ready to put my fur coat up for the summer and I actually increased some of my longs. Unfortunately that was climax peak in its purest form. I mentioned the earnings warnings in the chip sector after the close and the potential for some profit taking. There was also fear of the Jobs report and the impending Fed meeting. We all know that when the markets want to take profits they seize on any event as a reason for selling. As the week progressed the number of reasons to take profits grew into a laundry list as the talking heads on TV tried to appear all knowing. On Friday the new 52-week highs fell to only 169 and decliners beat advancers 5:2. Down volume was better than 3:1 over up volume. This was an even stronger show of conviction than the Tuesday rally.

The Dow retreated to fill its gap at 10550 from July 14th and trade at a four week low. It did NOT trade out of its range despite the drop from multiple tests of 10700. The Whilshire 5000 retreated to 12262 and right back to its range bound congestion range and comfortably above strong support at 12200. No worry here yet. Despite an implosion in the chips and the Russell the Nasdaq gave back only a weeks of gains to come to rest at 2175 and well above the bottom of its range. Still no problem here either.

Russell Chart - Daily

I mentioned on Tuesday that no +10% move goes unpunished and the Russell was up nearly +20% from its lows. Well the punishment definitely arrived with the Russell crashing -27 points from 688 to 661 in only three days. That -4% drop was clearly some mutual fund profit taking as the dog days of August finally appeared. The disappointing chip earnings on Tuesday night knocked the SOX back into its prior range with support at 470 and effectively ended the assault on 485-490 resistance. But, all of that news is now history and the real question is where do we go from here?

I would like to say that the dead stop on 10560, 2175, 1225 was the end of the selling. Unfortunately as much as I would like to see a rebound from here there may still be more weakness ahead. According to the Stock Traders Almanac August has been the worst month for the S&P for the last 15 years. It is also the second worst month for the Dow and the third worst for the Nasdaq. In six of the last eight years the losses in just the last five days averaged -3% for the major indexes. Has the selling just begun? Nobody knows but what we do know is that there will be a lot of volatility as the month progresses. Both sides will battle for control while funds reshuffle their portfolios in advance of the September/October buying opportunity. If the selling does continue the Dow has risk to 10250, Nasdaq 2050 and SPX 1185. My recommendation still stands to be cautiously long over SPX 1225 and short below that level.

Regardless of whether we go up or down I still believe the oil sector will be the best performer. Historical trends in crude pricing typically see gains in August/September and we want to be onboard for those gains. Once a post September decline in crude prices begins I think we exit our longs and begin targeting some buying opportunities on any major dip. The same scenario exists for the broader market. With the historical cycle suggesting weakness over the next two months we should be ready to exit any positions outside the energy sector and look for buying opportunities in Sept/Oct. For me the market turning point came a few days later than I expected but it still came. I was prepared for it and I hope you were as well. Now that the markets are back in their ranges we need to refrain from emotional entries hoping for a snapback and take our time picking targets. Keep your eyes on SPX 1225 and remember that markets go down faster than they go up. With the Fed meeting next Tuesday there is severe market risk should they eliminate the measured pace clause. Should they retain it we should rally again but watch out for a lower high.

I am going to be at an energy seminar this coming week where 90 companies will be giving their views on their future and the future of oil. I am doing continuing research on the coming oil crisis in preparation for an update to my oil report for Q4 of this year. I will probably have a lot to tell you next Sunday and hopefully some new oil plays for the next cycle. Until then watch SPX 1225, enter passively and exit aggressively if the market turns against you.
 

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