The bears finally got their wish as the various market factors began lining up in their favor. The four E's of earnings, economics, energy and expiration combined with Iran concerns and enabled the bears to get the upper hand. The Dow plummeted to 10665 for a loss of -213 points, and bulls were not able to slow the descent despite several strong support levels in the markets path.
Dow Chart - Daily
Nasdaq Chart - Weekly
Nasdaq Chart - Daily
This was the proverbial perfect storm for the markets with news flying on all fronts and none of it market friendly. Normally bad news from one front is offset by good news from another. On Friday it was all negative or at least that is the way investors reacted. While some earnings concerns were making news the biggest pothole was news about Iran. According to the AP Iran was moving its foreign currency reserves out of European banks to an undisclosed location. This was seen as a preemptive move ahead of any sanctions by the UN or a unilateral move from some European nation. Iran confirmed it was moving the money and this added fuel to investor concerns. If Iran is taking this step it suggests they are not going to buckle under UN pressure to abort their nuclear program. When taken into context with Iran's warning on oil earlier in the week it sent shivers through the market.
Iran said it could send global oil prices soaring higher if any sanctions were put in place by the UN or otherwise. They appear to be staging their forces, both economic and military, to prepare for tougher times ahead. Iran has the second largest oil reserves in the Middle East and is second only to Russia in natural gas. Iran exports 2.4 mbpd and represents nearly 10% of OPEC volume. There are fears that Iran may cease exports temporarily just to show the world what kind of power they have. They could easily send prices to $100 within weeks of any drop in output.
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If you recall my commentary from last Sunday I warned that Iran was in control of the oil card and not the UN. Last week everyone was worried about what UN sanctions could to Iranian oil and I warned that this was the wrong view. I warned that Iran could use its oil as an offensive weapon and could hurt the world a lot more than the UN could hurt Iran. Several days later Iran warned that oil prices could hit $100 if they cut exports and proved my point exactly.
Iran also has a strangle hold on nearly 50% of OPEC exports through their control of the Straits of Hormuz. This choke point for shipping of oil from Saudi, Kuwait, Iraq and other Persian Gulf nations is controlled by Iran. Over the last decade they have built hardened missile sites in numerous locations all around the straits. In the picture below the entrance to the Persian Gulf is on the left and Indian Ocean on the right. All the land on the top is Iran. The straits narrow to only 50km and is easily controlled by a few well placed anti-ship missile launchers.
Straits of Hormuz
Iran is fully aware of this and has fortified the area in anticipation of future conflict. You may wonder whom they were planning on fighting when they built these defenses over the last decade but looking at the political map today and their UN defiance I think the plan is now clear. They are in the drivers seat when it comes to controlling the world's oil supply. That makes them a very tough nut to crack for military planners. The straits are so well fortified that even U.S. navy vessels take extra precautions when forced into the narrow passage. They could shut down much of the regions exports without firing a shot simply by warning that tankers making the passage could come under attack. No shipper wants their half-billion dollar tankers sunk in the strait. The revenues from each tanker represent million of dollars per year to them not to mention the potential loss of a ship. Several times in the past we have seen tankers stack up in a holding pattern in the Indian Ocean for weeks while waiting for a potential confrontation to pass. Iran would not have to shoot at them all and clearly this is not the threat. Iran would only need to sink one in the narrow channel to slow oil movement or stop it all together. They could easily do this with missiles in place and no outside military could stop them. The sites are too spread out and consist of mobile launchers as well. Heck, just firing one missile at a tanker would create a floating parking lot in the Indian Ocean that could wreak havoc in the global oil markets. Over 15 mbpd of OPEC oil passes through the strait. Oil prices would rocket higher instantly if that 15 mbpd were held up for just a day or two and even higher for a multiple week delay. This is a SERIOUS threat in the making and Iran knows they hold the trump card.
On Thursday Vice President Cheney said a significant spike in the price of oil due to conflict with Iran was preferable to a nuclear Iran capable of threatening anyone with nuclear weapons. Iran has a history of belligerence and aggressive behavior with recent comments about wiping Israel off the map. Make no mistake. There is a conflict brewing and while it could take many months to come to a head the odds of a peaceful solution are slim. Cheney's comments should be a warning that they are willing to suffer higher prices after a military solution.
While Iran concerns were storm clouds over the market the foundation was under attack from another direction. High profile earnings disappointments were coming from all directions and earnings estimates were dropping faster than the thermometer. Citigroup, GE, Intel, Yahoo, Motorola, etc, all said something investors did not like and the results were not pretty. These were not the only culprits but their high profiles made the news worse. Intel fell -15% since its Tuesday confession, Yahoo -16%, Motorola -8%, Dow component Citigroup -5% on Friday alone. GE fell drastically short of estimates on revenue and lost -4% on Friday but the damage was felt across the board. GE is seen as a proxy for the economy and while the companies forecast was inline with estimates investors were disappointed with slowing revenue.
On the Nasdaq the news was just as bad. A whopping -54 point drop came after a flurry of weak earnings and guidance. The Nasdaq rise to a new high only a week ago came on the back of Google's addition to the Nasdaq-100 index. On Friday Google lost -37 points, its largest drop ever. The Nasdaq-100 benefited from Google's gain and imploded with Google's drop. The drop in Google came after it refused to honor a subpoena from the Dept of Justice for a random sample of search requests. Google said it was not going to honor the request and would fight it on grounds of competitive interest. They claimed the release of the data would give competitors inside information on Google's business. Google has archived EVERY search ever made on its site. That represents 200 million searches per day from 380 million unique visitors. Google has over 50,000 servers to store this data and over 400,000 advertisers that buy it on a per click basis. They want to keep all information private and not allow the outside world to look inside its operations. This is going to be a losing battle for Google and they could incur some additional Dept of Justice wrath for being obstinate. The DOJ said it does not want any user information but requires the search data to develop rules regarding a new child porn law.
While the bad earnings news seemed stronger than normal those that exceeded estimates were also penalized on Friday. The hero for the week was AMD and they gave up -4% on Friday as traders took profits. The actual breakdown of earnings to date does not show any significant change in trend but given the massive drop you would have thought all earnings had changed. With only 95 S&P companies reported, 58% beat estimates, 18% reported inline and 24% missed the target. Historically 60% beat and only 20% miss. This may not seem like a major change but it was the size and stature of the companies confessing that made the news worse. These were not small caps filling a niche market. They were major blue chip companies with many billions in revenue. They were not just techs but financials and multinationals. Earnings for the S&P have come in at +13.7% for the 95 companies reported. This is down from the estimates made last quarter for +18.6% growth but the cycle is still young. However, current overall estimates have fallen to only +12.5% growth down from 14.9% only a month ago. +12.5% earnings growth is nothing to complain about but the rate of decline is disturbing. Were it not for the energy companies we could have negative growth for Q4.
Analysts are still pounding the table claiming the string of double-digit quarters will continue even if earnings fall to 12%. The bears are equally quick to point out that more than +20% earnings growth over the last two years has not been enough to break the markets out of their range. If earnings of more than +20%, sometimes over +25% was not good enough for investors then what will the expectations for single digits later this year do for the markets? Historically the markets look 6-12 months ahead and earnings estimates in that window are shrinking rapidly. Guidance for 2006 has been less than stellar and the market is reacting to that fact. By next weekend over 250 S&P companies will have reported and the numbers should be clearer. However, I believe that most early blue chip reporters have better numbers than those smaller companies that follow. Typically the bigger the market cap the earlier they report and the better the results. This suggests the percentages could decline by next weekend except for the help from energy companies.
Crude Oil Chart - Daily
Soaring energy prices are not helping that earnings picture for non-energy corporations. With the many factors impacting oil prices this week investors are afraid that energy will be a serious drag on the global economy for the next two years. There were problems other than Iran pushing oil prices higher. In Nigeria rebels are continuing their attacks on oil facilities and Shell is evacuating personnel until the situation improves. Nigeria is a large exporter of light sweet crude and a drop in those exports will push prices sharply higher. Output has fallen by -200,000 bpd over the last two weeks. In Oslo Norway, Statoil reported that six platforms had been shutdown or had production halted significantly due to leaks, fires, dangers of explosions and weather. More than 350,000 bpd in production was offline.
The U.S. Minerals Management Service (MMS) released a report showing that hurricane damage in the Gulf was much stronger than previously thought. Katrina totally destroyed 46 platforms and Rita destroyed 69. 20 others were seriously damaged by Katrina and 32 more were heavily damaged by Rita. Over 83 pipelines were damaged including 28 large diameter pipelines of 10" or larger. Only 10 of those 28 have returned to service. The MMS said 15% of gas production and 25% of oil production was still offline and could be offline until late Q2 or early Q3. Approximately 255,000 bpd and 400 mcf of gas is not expected to be restored prior to the 2006 hurricane season. A shipping accident in Port Arthur on Tuesday has blocked the channel and crude deliveries to two refineries. They have been slowing production and may be forced to shut down completely by this weekend. The government has authorized 871,000 bbls of crude to be loaned to them out of the strategic reserve until the channel is reopened. The drop in output is just one more glitch in the supply equation.
Goldman Sachs said conditions were right to push oil prices over $70 by summer. Not to be outdone CIBC World Markets said oil prices could easily hit $100 this year. CIBC did a study of current production, production coming online by 2010 and the depletion rate of current fields and said Peak Oil for conventional production actually occurred in 2004. They are counting deepwater drilling as non-conventional oil and that is not expected to peak for several more years. However, debating words and categories will get us nowhere. The key here is that CIBC World Markets has added their voice to the Peak Oil discussion and it is not one that will be taken lightly. This suggests oil prices are headed higher and Iran, Nigeria and the North Sea outages are just signposts along the way. Those factors are adding $10 to the current price of oil according to analysts. Should tensions ease we could be back at $60 very quickly. The prospect of $70 oil any day now and not as a result of some Gulf disaster is going to drag on earnings and consumer spending. Remember $3 gas last fall? The February Crude Oil contract closed at $68.15 on Friday, only a heartbeat away from $70. However, since the February futures contract expired on Friday the end of life short covering could have been a big part of the gains for the week. The new front month contract, March, closed at $68.55 after hitting $69.20 intraday.
Consumer Sentiment climbed in January by +2 points to 93.4 but this was an anemic bounce. Rising gasoline prices, higher utility bills and constant warnings about a declining housing market are combining to pressure consumers. I reported last week that refinancing was slowing appreciably as home values were falling, at least in Colorado. This is preventing homeowners from continually using home equity to pay off credit card bills and cover unexpected expenses. Tighter lending rules are keeping marginal borrowers from qualifying for loans. I am selling a $500K second home here in Colorado and the purchaser has had three mortgage companies turn him down in the past week. We have already extended the contract twice due to loan problems. This type of problem is going to accelerate if the economy begins to weaken. First time homebuyers borrowing 100% has risen to 43%. In 2005 20% of new loans were interest only, up +5% from 2004. Sub-prime borrowers rose to 28% of the market in 2005. Foreclosures are already at record highs in several areas of the country and these types of loans will push that number even higher with any economic weakness. Flippers are finding their spec homes staying on the market longer and price competition is increasing. The number of homes for sale is rising sharply. Homebuilder optimism fell in 3 of 4 regions in the report issued on Wednesday. This is just one more set of reasons why economic growth may slow as 2006 progressives.
The SOX soared to a new two-year high on the 12th at 539. After declining to 508 intraday on Intel's numbers it rallied back to 538 on Thursday's short squeeze. That Thursday rally was completely erased to close at 512 on Friday and the low of the day. The AMD news was short lived and the book-to-bill on Thursday night became the real news. The BTB came in at 0.96 late Thursday, up only +0.03 from the prior month. This means for every $100 of orders shipped only $96 of new orders was received. This is right inline with the numbers for the last six months and far weaker than you would have expected for a SOX rally that took us from 413 in October to 538 in January (+30%). It appears that great chip results were already priced in and without some great results from the smaller companies reporting next week that rally could be over.
SOX Chart - Weekly
There was no joy on Friday on any index. Dip buyers and bottom feeders were absent and volume was huge. In fact volume increased every day last week to a high for the year on Friday at 5.8 billion shares. The down volume on Friday was six times up volume with decliners 2.5:1 over advancers. These are very negative internals that would normally present a very negative outlook.
Volume table for last week
The number that stands out the most to me was the new 52-week highs on Thr/Fri. Why would so many companies be making new highs with the markets so negative? After researching it for a few minutes the answer was clear, energy companies led the list. SLB, HAL, SU, KMG, UPL, BDE, UDRL, PDC, WFT, CEO, BHI, DPM, HOC, TLM, XTO, GSF, DRQ, to name a few. I could go on but you get the picture. Remove the energy sector from the indexes and Friday's volume imbalances would have been much worse.
Much of the volume was related to option expiration for January. Some futures contracts including the current crude oil contract expired. This created a significant amount of additional volume as option traders were punished by futures moves. The earnings problems last week put bulls in a precarious position. Those with long positions on companies scheduled to report over the next couple weeks were faced with a decision after last week's disappointments. Do they continue to hold and hope for better times ahead or bail out and protect their capital. It appears they decided to bail. After the short squeeze on Thursday gave them a last minute reprieve they exited in mass on Friday. Those holding January contracts were faced with a complete reversal of fortunes in only 24 hours.
The Dow dropped -213 points and the biggest one-day percentage drop since May-2003. The Nasdaq fell -54 points and the biggest drop since Jan-2005. The next largest drop on the S&P dates back to April 2005. The magnitude of the drops was even more apparent after the strong bounce on Thursday. The Nasdaq rebounded more than +48 points from Wednesday's low to Thursday's short squeeze high but that spike over 2300 attracted sellers in volume. Friday's decline actually started at 2:PM on Thursday on the Nasdaq and there was never any doubt about direction. The drop took the Nasdaq back to under 2250 and there was no attempt to buy the closing dip.
The Dow fell from Thursday's high at 10915 to close at 10665 and a two-month low. Hard to believe the Dow was at a new 4.5 yr high just six days earlier. Friday's drop erased the gains for the entire year putting the Dow 52 points into negative territory for 2006. 10700 was the last material support level for the Dow before a potentially long drop to something in the 10400 range.
The S&P lost -23 points or nearly -2% to close at 1261. Considering it was only 7 points away from a new 4.5 yr high at 1288 on Thursday the drop was very dramatic. As our indicator of choice for market direction it has now slipped into a negative bias. The game plan for the week was to buy dips above 1270 and then short any break of that 1270 level. That plan worked well with Tuesday's drop to 1272 and +16 point rebound. With the break of 1270 it sets up a potential drop to the next support level at 1250. Should that level fail 1200 becomes the next target.
SPX chart - Weekly
SPX Chart - Daily
I am not completely convinced that market direction has changed. While our indicator at SPX 1270 remains in force I feel there were far too many external influences on Friday to assume that the true market direction has appeared. Option expiration could have provided an extreme external influence due to those earnings that set the ball in motion. Just like Thursday's short squeeze triggered buy stops for shorts the Friday drop triggered sell stops for longs. Monday morning should provide some more expiration volatility as exercised positions are cleaned up and retail traders on the sidelines try to determine market direction. Given the severity of the drop, the TRIN at 2.59 and the VIX at 14.35 and nearly a three-month high there is plenty of reason to expect a bounce. If it does occur I would watch SPX 1275 as a critical resistance level and 1270 as critical support. If a bounce does not appear then simply remain short with 1250 as the next support target followed by 1200. If it does appear I would probably wait for a move over 1275 before entering any trading longs. Use that five point zone between 1270-1275 as a neutral zone and trade accordingly on any move out of that range.
The current bull market started back in July-2002 and has stretched its gains for 42 months without a material correction of -10% or more. The average length of a bull market is 38 months making this one overdue for a pause although two years of range bound trading probably qualified. For example in the bull market that stretched from 1996-2000 there were six -10% or larger corrections. January is one of the most volatile months of the year and that distinction has been well earned. I posted some numbers several Sunday's ago outlining the market movement in recent January's past and this month has finally fallen right into that pattern after a surprisingly strong start.
To further complicate our immediate future there is a strong slate of economic reports due out next week along with more than 450 earnings reports. These will be closely followed by Greenspan's last Fed meeting on Jan-31st. Given the rising oil prices, and slowing economics like we saw in the Philly Fed last week, there are more than a few investors expecting an end to rate hikes on the 31st. They are likely to be disappointed. The market could anticipate a favorable outcome but I believe in the long run it will just be another artificial bounce. The end of Fed hikes is already priced in according to many analysts and we may not get the usual post hike cycle rally. Economics are simply too weak and there is nothing especially positive on the long-term horizon. Energy prices are going to be a crippling anchor to economic growth and oil over $70 this time will be a major weight on the market. All these factors make it even more important to trade the plan rather than trade on emotion. Focus on 1275 resistance and 1270 support if we get a bounce. Remain long over 1275 and short under 1270. Add to shorts under 1250.