Option Investor
Market Wrap

Expiration Whimper

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August options expired with only a whimper on Friday as the markets erased an early morning gain when oil worries returned. It was a very low volume day with advancers and decliners evenly matched. Rather than a defining market event it was simply a late summer Friday with few traders around for the closing bell. From the market action I doubt few even returned from lunch.

Dow Chart - Daily

Nasdaq Chart - 30 min

SPX Chart - Weekly

There was only a couple economic reports and nothing material for traders to worry about. Internet Sales rose to $21.5 billion in Q2 from $19.8 billion in the same quarter in 2004. Yawn. The ECRI Weekly Leading Index came in unchanged from last week at 135.6. Snoring now, Zzzzzzz. With no economic reports traders were left to focus on stock news and news from around the world.

The morning news was dominated by the surge in oil prices due to multiple events. The state oil company in Ecuador, Petroecuador, ceased production of oil after protestors took control of some installations in a long running dispute with the government. Ecuador's state run oil company exports 210,000 bbls per day but that is less than half the total exports from that company. The majority of Ecuadorian oil is exported to America. The protestors are demanding foreign oil companies operating in the region provide financing for infrastructure and more jobs for local workers. Protestors blocked roads and sabotaged equipment in the invaded oil camps. Petroecuador declared force majeure on its oil exports invoking a clause in their export contracts allowing them to stop exports due to events out of their control. Other independent oil companies in the area including Encana, Occidental and Petrobras also restricted output from locations affected by protestors.


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Ecuador was not the only problem area for oil. Shell has 14,000 bbls per day of lost production in Nigeria as political unrest returned to local communities. Nigeria has been a trouble spot for months despite efforts to resolve the problems. Also on Friday three Katyusha rockets were fired at U.S. warships in a Jordanian port and an Israeli port. One Jordanian soldier was killed. Two rockets were fired in the Jordanian port of Aqaba.

Venezuela also reported a refinery fire on Thursday that knocked out a significant portion of its 440,000 bbl a day production. The refinery is only producing 150,000 bbls as of Friday and it could be sometime before full production is restored.

Also impacting the price of oil was a weather warning that the coming winter could be colder than normal based on changing weather cycles. Over the last 30 years any storm season that had more than 18 tropical storms was followed by a drop of -3 to -5 degrees in the average temperature in the North East. For this season we have already seen nine storms with predictions of up to 20 more, 9-11 of which could be hurricanes. The weather patterns that produce these storms are the same weather patterns that produce cold North Eastern winters. It is a factor of water temperatures and currents that upsets the normal pattern.
December heating oil spiked back to $1.93 and there were reports of retail prices surging over $2.55 a gallon. That is coincidentally the same price as the national average for unleaded gas.

September Light Sweet Crude Chart - Daily

All of these problems sent crude oil sharply higher to close at $65.30 and a gain of +2.08 for the day. Oil had fallen from its high just over $67 last Friday to a overnight low of $62.25 on Thursday. The +3 bounce revitalized energy stocks and brought them back from the brink of disaster. Traders had been taking profits by the truckload over the last week ahead of the expiration on the September crude contract. Hedge funds with monster positions were dumping oil after hitting the record $67 level last week. We expected a monster move this week with expiration ahead. Of the last 12 monthly expirations there were $5-$7 moves in crude the week before expiration. 10 were up, 2 were down. Given the end of the peak driving season only two weeks away it appears hedge funds decided the run was over and bailed out. While the end of summer will slow demand for gasoline it will increase demand on heating oil, diesel and jet fuel.

With jet fuel in short supply you can bet the majority of airlines are hoping for a Northwest Airlines strike for more reasons than normal. Northwest could strike as early as midnight on Friday. Los Angeles International came very close to running out of jet fuel earlier this week. The problem is serious enough that many airlines are already cutting back on flights to save on expenses. Northwest announced a -17% drop in flights just last week in news unrelated to their impending strike. Northwest has seen a +$500 million increase in fuel costs so far in 2005. Air traffic in July reached four-year post 9/11 highs despite the increase in fuel costs. That traffic would have increased again this fall as business travelers returned from their holiday schedules. This would put additional strain on refiners and make any disruptions in global oil supply even more critical. The fourth quarter is typically the highest oil demand for the year and there is very little cushion in global supply. The EIA said just last week that there was only 200,000 bbls of excess global capacity of light crude. Since global conditions have not changed it is obvious the sell off this week was simply cyclical profit taking.

While the oil news was the focus of the morning trading the afternoon was spent discussing the Merck Vioxx trial verdict. Merck was found to be liable for the death of a triathlete in Texas and the jury awarded the widow over $229 million. There are between 4000 and 7000 cases pending and the ramifications for Merck are very serious. Merck will have to increase its reserves for these pending cases based on the size of the award. It also faces a surge in new cases based on the loss. Merck will appeal and the award will be cut substantially under Texas law but the stage is set for a disaster. Some reports now claim that over 100,000 people have suffered heart attacks while taking Vioxx. That makes the high estimate of 7000 current cases only the first wave with the potential for tens of thousands more. Evidence presented in the trial showed Merck knew of the dangers early in the cycle and suppressed the news because of the high profitability of the drug. This may be a gotcha where the vast magnitude of the cases will sink the Merck ship. In the 1970s A.H. Robbins began marketing a contraceptive device for women called the Dalkon Shield. A.H. Robbins disregarded cautionary medical advice concerning a flaw in the device and thousands of women suffered serious injuries. Eleven years later AHR filed bankruptcy under the weight of 300,000 injured claimants. A trust was created for the claimants and over $3 billion was paid out in the biggest damage recovery ever. The potential for damages for Merck is well over that level. Few died from the Dalkon Shield and I have seen estimates that more than 20,000 deaths could have been attributed to Vioxx. I seriously doubt that is the case but anyone dying of a heart attack or stroke while taking Vioxx will have their families jumping on the Vioxx train in hopes of recovering some money. Whatever the eventual outcome of the Texas trial the damage to Merck has been done and it can only get worse. MRK stock lost -10% after the verdict was read. Analysts will probably dump on Merck on Monday with gloomy outlooks and prices are likely to continue further down. Merck's 5% dividend has been considered sacred but that is now in danger. Even if it were not it would take a long time at 5% to recover the losses expected in MRK stock over the next five years.

Other than oil and Merck it was a boring summer Friday that wandered aimlessly on very low volume. Barely 3B shares were traded across all markets and volume was evenly split between advancers and decliners. There were no signs of option expiration gyrations as those traders still trying to make a buck marked time until the close. What little gains the Dow had managed to retain by late afternoon were erased with the drop in Merck when the news broke. All the major indexes with the exception of the NYSE Composite closed within a handful of points from the flat line. The NYA was buoyed by gains in the energy stocks. The Dow was showing the most resilience with the Nasdaq on the verge of another support break at 2135, or 1575 on the NDX.

After the close Semi.org released the semiconductor book-to-bill numbers for July. The headline read "Book-to-Bill rises to .93 in July from .90 in June." You know how I hate headline numbers. If you research this further you would find that the June number was revised down to .90 from .93 in this release. For me that makes Friday's .93 headline number a flat report because we used the previously reported .93 number as gospel all month. Using this revision theory semi.org could always report a higher number by revising the prior number down in the boilerplate of the report. Even worse the BTB number rose ONLY because the billing numbers have fallen for five consecutive months and nine of the last ten months. Billings in July fell to $1.097B from $1.152B in June and its spike high of $1.330B back in February. Over the same period bookings have remained relatively flat at $1.0B. To put this into English the BTB was 0.77 in February when billings were $1.3B and bookings were $1.024B. In July the BTB "rose" to .93 with billings dropping to $1.097B and bookings still flat at $1.020B. Orders remained flat but the ratio rose because shipments are dropping so fast. Despite how they want to spin this number the bottom line is clear. The chip business is NOT seeing any rebound and sales are about -33% below their highs in 2004. I am sure numbers will improve somewhat as seasonal orders for holiday products hit the tape but there is definitely no rebound in chips. On the flipside bookings are not declining either. The chip sector is patiently treading water until the next order cycle appears. There are no must have products on the horizon and with energy prices likely to depress corporate profits the next build cycle could be moving farther into the future.

So far the SOX has been holding over support at 460 but there is a clearer pattern of lower highs. The lack of any meaningful move off that 460 support level has produced an even more negative pattern on the Nasdaq. We clearly have a downtrend in progress on the Nasdaq and it barely budged off of support at 2135 for the last two days. There is growing weakness in several high profile Nasdaq sectors and the dip buyers have not been able to overcome the increasingly heavy overhead supply.

SSOX Chart - 90 min

SPX Bar Chart - Weekly

Nasdaq Chart - 90 min

The SPX chart has moved into negative territory where 1225 is now resistance instead of support. Twice this week 1225 has been a solid top and even the rebound in the energy sector on Friday failed to break that resistance. For the last six weeks my recommendation has been to be cautiously long over 1225 and short below that level. We are in that lackluster period in the economy and on the calendar where negatives seem to be out weighing the positives and the market is looking increasingly heavy. This is one of the worst periods on the calendar for the bulls with rising volatility and almost daily spikes producing false hope. We have passed the time in August where a rebound from the initial August dip normally occurs and I think bulls should give up on that hope. I continue to think we will see new lows ahead and we are in for a decline into the October period. Even the -7% drop in oil, -10% in some oil stocks, was not enough good news to lift the market out of its doldrums. The monster jump in the Philly Fed Survey from July's 9.6 to 17.5 in August was also not enough to reverse the growing negative sentiment.

Oil prices, actually gasoline prices, are beginning to have a negative drag on the economy. Retailer after retailer has warned over the last two weeks that sales were slowing. This has produced a change in sentiment at exactly the wrong time of the year, the weakest period on the market calendar. I am actually glad to see it happening in hopes that normal market cycles return. I believe that gasoline prices will moderate over the next couple months as demand moves into jet fuel, diesel and heating oil. Those are still critical areas but rising prices there are less a drag on the consumer than gasoline prices. By the end of September the consumer should have digested the gasoline spike and hopefully prices will have subsided to something more manageable. If there are no damaging hurricanes then Q4 oil prices should find an early top and any dip into October will be a buying opportunity for stocks. From my viewpoint we are setting up for a textbook Q4 rally out of a September decline. Because of the remaining bullish undertones I am only looking for a slight decline into the end of Q3. I see Dow support at 10250, Nasdaq 2050, SPX 1185, Russell 625 and 11800 on the Wilshire 5000. Obviously those are just calculated guesses and markets tend to take on a life of their own once sentiment changes. Once they start reacting to bad news each additional news item tends to accelerate the drop. Trends are normally overdone in each direction and there is nothing to make this year any different. The key is our market posture. This week we do not care where the bottom might be only that we are short under SPX 1225. Let the markets tell us when a bottom has been found. Expect short rallies, some likely violent as shorts eventually get caught flat-footed and have to race to cover. Use any abnormal rebounds as new entry points for shorts/puts until the trend changes back to the upside. Continue buying dips in oil and keep your stops tight as we near the end of the driving season. Expect to trade oil positions from now until March instead of just buying and holding for the long term. For investors the next 45 days are a recurring nightmare of false starts. For traders it is a paradise of short-term profits. Just remember to enter passively and exit aggressively and definitely don't get married to your positions.

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