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Market Wrap

Trend Change

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After weeks of trading in a tight 20 point range the S&P has finally weakened and closed at a 5-week low of 1219. With oil prices moderating as the September contract comes to a close the energy stocks no longer provided support to the S&P and the result was a stronger reaction to the double Es of earnings and economics. Inflation due to high energy prices is accelerating and multiple earnings warnings suggest while consumers are feeling pain retailers are going to be pinched.

Dow Chart - Daily

Nasdaq Chart - Weekly

The morning started out with a negative bias from several earnings warnings and the economic reports did nothing to correct that bias. The Consumer Price Index spiked +0.5% driven by a +6.1% increase in gasoline prices. The core rate minus food and energy rose only +0.1% but as we know it is tough to live without those components. The core rate is normally quoted as the real inflation rate but that argument is wearing thin given the high cost of energy filtering through the system. The sharp jump in inflation caused bond yields to drop sharply as investors fearing a new inflation cycle bought bonds instead of stocks. Gasoline prices have risen much more than the +6.1% shown in the report but the gains spanned the July/August break suggesting the August CPI is also going to be very strong. Gasoline has risen +19.5% over the last 12 months.


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Industrial production rose only +0.1% for July and well under the consensus gain of +0.6%. Durable goods fell sharply as did the mining sector. Capacity Utilization fell to 79.7% and the prior months number was revised down from 80% to 79.8%. Utilization has been stuck in a very tight range for the last year with the last two months actually a sharp increase in utilization. This month's minor drop should not be seen as a material drop in activity. Much of the drop in production came from a drop in auto production as automakers slowed production for the model year change and for the anticipated post sale reduction in buying. The employee discount program worked so well the automakers fear the next couple months could be very bearish. Rising energy prices also curtailed production as electrical prices rise for manufacturers over the high demand summer months.

New home construction was flat for the month at an annualized rate of 2.042 million homes but housing permits were up strongly. Permits have been rising since May and remain very strong currently at a 32-year high. The continued low mortgage rates are keeping the boom alive even as we are seeing projects cancelled or delayed in several of the high activity housing areas.

Chain store sales fell for the second consecutive week as gasoline prices weighed on consumers. The -0.2% headline number was well off the -0.8% drop in the prior week but a new trend is appearing. That trend is for consumers to hoard cash to pay for gasoline. The worry is filtering through the retailers with Wal-Mart warning this morning that the high gasoline prices are going to impact sales in Q3.

Wal-Mart dropped -1.50 after posting a +5.8% jump in profits for Q2. That was the smallest quarterly profit gain in four years. Wal-Mart had an internal goal of profits rising faster than sales and that also failed for Q2 with sales rising +10.2%. WMT said profits for Q3 were now expected to be between 55-59 cents and analysts were expecting +61 cents. As the biggest retailer in the U.S. Wal-Mart is considered a proxy for real inflation pressures at the consumer level. Wal-Mart said it spent more than $30 million in additional fuel costs for its truck fleet over the quarter. Wal-Mart is seen as a pure reflection of consumer sentiment since over 100 million people visit a Wal-Mart store each week. These customers are typically the consumers with the least amount of disposable income and those where inflation pressure will appear first. Wal-Mart was not the only retailer to warn higher gasoline prices were putting a drag on consumer purchases. BJ's Wholesale Club cut its full year profit forecast saying higher gas prices were putting pressure on their margins. BJs beat the street by a penny in Q2 but lowered estimates for Q3 to the lower end of its range. Disk's Sporting Goods fell -6.33 after warning they would post a loss in Q3 and post lower earnings for all of 2005. TJX, operator of TJ Maxx and Marshals fell after posting lower than expected earnings on weaker than expected sales growth. Retailers in general are struggling and competition for disposable dollars going into the Q4 holiday shopping season is going to be tough without a significant drop in oil prices.

Warnings, earnings misses and downgrades were all traders had to digest today and the only commodity in high demand was Maalox. Deere lost -8 after saying that dry summer weather had impacted its sales forcing a production cut in August. Earnings were flat but the drop in production caused traders to anticipate a drop in earnings for the current quarter. Deere said the drought had forced them to accelerate seasonal layoffs and predicted equipment sales could drop -13% in the coming quarter.

Gateway posted its first profits in quite a while but it did not keep them from getting hammered for a -20% drop on weak guidance. The price war between giants Dell and HPQ is erasing market share from Gateway as the smallest player in the group. Gateway does not have the component volume to compete on prices with the giants despite a valiant effort.

Home Depot was the exception to the warning rule today with a +14% jump in profits, raised guidance and affirmed sales growth for the full year. It was not enough to protect HD from losing $0.94 on a tough market day.

After the close AMAT reported earnings that beat estimates by a penny but fell short on revenue. New orders for Q3 fell to $1.47 billion from the Q2 rate of $1.63 billion. This was only a -5% drop and slightly better than the -10% decline AMAT had predicted. This was -40% below last year's levels. AMAT CEO Mike Splinter said industry conditions remained challenging. AMAT was already down on the Gateway earnings guidance and did not drop in after hours. Once their conference call got underway AMAT rose +50 cents.

Also announcing earnings was Hewlett Packard, which posted a gain of +36 cents beating estimates of 31 cents. Sales rose +10% to $20.8 billion. HPQ raised estimates for the current quarter and CEO Mark Hurd was upbeat about their performance for this quarter and the future. HPQ jumped +2 in after hours. I reported last weekend that after the Dell and Cisco disasters the expectations for HPQ had dropped to the lower end of the spectrum and there was little potential for a negative reaction. The increased negative expectations setup the potential for a positive reaction to any better than expected results. Several commentators after the close speculated that HPQ was on the verge of taking share away from Dell and Dell had little hope of increasing margins in the face of a suddenly renewed HPQ.

Oil prices continued their two day decline but only slightly by closing down -16 cents at $66.08. Intraday the crude contract traded as high as $66.85 but retreated at the close to a slight loss. Oil stocks rested for the second straight day but losses were light in most cases. Given the -120 point Drop in the Dow and the -29 point decline in the Nasdaq oil stocks behaved relatively well. Most notable however was the lack of support for the S&P. I mentioned last weekend that energy stocks had supplied a +3% bias to the S&P and without that continued support we could see a change in the trend.

September Crude Chart - Weekly

SPX Chart - Weekly

That trend change was exactly what we got with the S&P closing at a five week low at 1219 and well under our 1225 sentiment indicator. The worsening sentiment pushed the declining indexes to levels that have violated strong support. The Dow lost support at 10575, 10550 and at 10535 to close just a dozen points away from 10500. 10485 is the last bastion of support before a potential return to 10200-10250.

The Nasdaq broke support at 2150 and like the Dow is very close to a potential drop back to the 2050 level. The downtrend for the Nasdaq has been in place since the Aug-3rd high at 2219 and has now accounted for an -80 point drop. In recent weeks we have seen company after company give weak guidance for Q3 and in some cases for the rest of the year and this has erased the positive reports at the beginning of this earnings cycle.

The AMAT earnings may give badly needed support to the SOX, which closed slightly under critical 460 support on Tuesday. The SOX needs to maintain its hold on this level to prevent the Nasdaq from developing a severe decline. Chips and small caps are critical to the Nasdaq sentiment and neither were of any help on Tuesday. The Russell collapsed -11 points to close at 654 and below the same relative support levels from early July that the Dow and Nasdaq have yet to break. The positive HPQ and AMAT news may help provide a rebound at tomorrow's open but I would not bet on it holding.

SOX Chart - Weekly

With the S&P below 1225 and the Dow closing under its 200-day average at 10526 the stage is set for the next leg of the August decline. I heard one analyst claiming the drop in oil prices would support a market rally. I hate to remind him but oil is only -90 cents off its all time high at $67.10 set on Friday and currently rising in overnight trading. Nothing has really changed and that minor dip has only served to provide a better entry point for those wanting to buy oil stocks on weakness. I would definitely not call it a market support point. If anything we are just biding our time waiting for the next oil incident to occur and a new high to form.

Ironically a rebound in oil prices could supply some much needed support to the S&P. I doubt it would be enough to break out of this index spiral but only time will tell. We could be just hours away from the next refinery outage or oil incident and traders are just passing time waiting for the next bounce. We saw only a minor dip in gasoline futures to $1.97 a gallon and natural gas spiked to a new closing high at $9.74 as the summer heat wave continued to keep the pressure on supplies. Continue to buy oil stocks on any dip until after September.

I would continue to maintain the same market bias I have been recommending for the last month. Remain long cautiously long over 1225 and short below that level. My bias has returned to expectations of a continued market drop given the sentiment and the date. August and September are not know for being kind to traders and despite the late start the outlook is for a continued seasonal decline. The next real support levels are Dow 10250, Nasdaq 2050 and SPX 1185. Just keep those stops tight, enter new positions passively and exit aggressively if a sudden directional change appears.

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