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Market Wrap

Volatile Week Produces No Gains

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For the week volume was extreme with the last four days posting over five billion shares and Thursday topping 6.1 billion. Strong volume at market highs is normally a very good sign but the internals are not confirming this bullishness. New highs declined substantially over the prior week and the advancing and declining volume have been almost dead even. This is almost a picture perfect example of distribution and a warning about things to come.

Before reading any further look at the chart below. Based on this chart with the blue line as support and the red as resistance, would you buy this chart? The answer will be disclosed later.
No cheating!

Support - Resistance Bar Chart

April markets went out with a whimper but an economics left with a bang. The key focus on Friday was the GDP for Q1, which came in at 4.8%. This was slightly under the consensus estimates of +4.9% but nobody is complaining. This was a substantial increase from the +1.7% growth in Q4. That quarter was depressed as a result of the hurricanes. Consumer spending on durable goods contributed strongly to the growth. Durable goods declined -16.6% in Q4 but rebounded a very strong +20.6% in Q1. Housing declined -2.6% compared to -2.8% in Q4. Government spending jumped +10.8% compared to a decline of -2.6% in Q4. There was a large increase in the defense sector with a +10.3% increase in spending along with a +11.7% jump in non-defense. Inflation actually declined to a modest +2.0% in Q1 compared to +2.4% in Q4. The +4.8% GDP headline number was the strongest growth since the +7.2% jump in Q3-2003.

The NAPM-NY posted yet another gain to 387.2 for April compared to 378.9 in March. After a long period of gains we may be heading for a potential dip. The six-month business outlook fell to 50 from the March reading of 70. The current conditions index sank only slightly to 66.5 from 69.1 and suggests any potential weakening of business conditions could be slight.

The Chicago PMI fell to 57.2 in April from 60.4 in March. This was below consensus estimates in the 59-61 range. Small increases in production and inventory components were offset by steep declines in order backlogs, new orders and a higher prices paid component. Order backlog fell to 44.8 from 51.6. Any number under 50 is a negative component while numbers over 50 indicate expansion. Employment also fell from 55.6 to 47.2. This report was simply another sign that the economy is losing steam as the Fed predicted. The Chicago PMI typically correlates with the national ISM index of manufacturing and suggests we could see some weakening when the ISM is released on Monday. This should not be seen as a major problem just a slowing in the cycle.

Another sign of slowing inflation was the Employment Cost Index which rose only +0.6% in Q1 compared to +0.8% in both Q4 and Q3 of 2005. This was substantially below the consensus estimate of +0.9% and shows that worry about accelerating wage pressures could be over blown. Other than a one-quarter uptick in 1999 this was the slowest growth in wage inflation since the mid 1990s. The cost of benefits also slowed sharply to +0.5% compared to +1.3% and +1.1% in the last two quarters of 2005. The Fed should be very pleased with this trend as it takes the pressure off future hikes.

Consumer Sentiment surprised analysts with a drop to 87.4 from 89.2 reading earlier in the month. Compared to the gains in Consumer Confidence earlier this week this was a disappointment. The decline was due to a sharp drop in the expectations component from 76.0 to 73.4. Analysts blamed the drop on the constant press on sharply rising gasoline prices over the last three weeks with the $75 crude headline a showstopper for the average consumer.

Monday's reports include Personal Income, Construction Spending and the ISM index. The ISM index and the Jobs Report on Friday are the two key reports for the week. The ISM is expected to be flat at 55.0 and the Jobs report is expected to show 198,000 jobs were added in April.

The tame economic reports provided Ben Bernanke with the opportunity to toss the markets a bone on Thursday. Bernanke all but said that the hike in May could be the last one until the Fed has time to see how the existing hikes impact the economy. With inflation tame and the economy expected to coast into the second half there is no urgency to continue raising rates. His key point was that a housing-driven slowdown was now in place and the bubble potential had eased. They still want to be data dependent but Bernanke also said they reserve the right to act independently of the day. Okay, have your cake and eat it to. That is fine with me but how is the market supposed to anticipate your moves? The comment that sent the markets soaring was the following: "Even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives."

That appears to mean they are going to cease fire after the May hike BUT keep the gun loaded in case the inflation monster finally raises its head. Basically the tightening bias will remain in place but the Fed may take a pass or two without changing their language. The statement at the May-10th meeting should be changed to reflect the new wait-and-see stance. The odds of May being the last hike in this string increased substantially after the testimony. The Fed funds futures were pointing to a 62% chance of a June hike before the testimony but that fell to only 35% chance by days end.

Follow the Volume

If you follow the volume you follow the money. After spending several weeks stalled at these market levels this change in Fed stance should have produced a strong gain. Instead the morning bounce deteriorated and continued weak into Friday's close on very heavy volume. More than one analyst echoed my feelings that the probable rate hike halt in May is already priced into the market. In fact the volume last week was the largest volume week since the week of July-22nd 2002. That just happens to be the week where the Dow completed its initial plunge from its March 10673 high to the July 22nd low at 7532. This was the first bottom of the triple bottom seen over an eight-month period.

Volume for last two weeks

Volume for July bottom 2002

Chart of Dow for 2002

Nearly 27 billion shares traded over the last five days and that is a significant warning. Volumes that high ONLY occur at market tops and bottoms. If you will note the A/D volume for the last week in the table above it was nearly dead even with the exception of Thursday where the short covering Bernanke spike at the open skewed the numbers. You should also note that the new highs for last week (1922) were substantially lower than the new highs for the prior week (2862). If the markets truly had a bullish bias those new highs would be growing. If you take an unbiased look at the internals without regard for the Dow and SPX levels you should see impending weakness.

Now for the answer to the earlier quiz. If you answered truthfully to the chart quiz you should have said "Heck yes, I would buy that chart at the obviously strong support." That was a weekly chart of the Dow but I inverted it and removed the identifying tags to allow you to form a somewhat unbiased opinion. I know 95% of you cheated and skipped ahead but you will still get the point.

If you would buy that chart because support was so obvious then you should sell the correctly positioned chart below for the same reason because that support on the inverted chart was ACTUALLY resistance. If you rule out your bias and only look at the chart for direction then the real trade emerges. Add in the notes on the volume and swap the color of the support/resistance lines and you should be worried about the markets future. This is a picture perfect example of distribution at a market top. Add in repeated accounts about a slower economy in the second half, the worst six months of the year beginning on Monday and some very disappointing earnings from companies like Intel and Microsoft and the reasons to buy become very few.

Weekly Dow chart

Of course nobody can predict the market direction at any given point. Iran could capitulate next week and the Nigerian rebels sign a peace accord allowing that 450,000 bpd of light crude back into the market. Oil would crater and the markets would explode. Pigs could also learn to fly but I am not counting on it. Still, I could be completely wrong about the distribution but in my opinion the signs are crystal clear. Offsetting the negative internals could be a Fed pass at the May meeting or a sudden string of miraculous tech earnings. Neither is likely. With nearly 60% of the S&P reported over 70% of those companies have beaten the estimates. This compares to the 57% average dating back to 1992 according to Thomson Financial. In fact if you exclude a dozen or so high profile exceptions earnings have been outstanding and guidance is also stellar. Maybe you are wondering why the S&P has stalled at the 1310-1315 level since March 15th. Surely the outstanding earnings news can break that stalemate. Evidently not! The markets rose to these levels on the expectation of great earnings and on the expectations that the Fed was nearing an end to the rate hikes. This good news is already baked into the cake.

I am sure you have noticed the severe haircuts companies are suffering when they report anything but an obscene earnings blowout. Those with even a hint of a miss or weak guidance are getting killed. Take Aetna on Thursday. Aetna was knocked for a -20% loss on Thursday, -$9.33, after beating the street by a penny. The reason for the drop was an uptick in costs (medical-loss ratio) to 79.4 from the 2005 level of 76.9. This measures the cost of providing service to the amount paid for that service. Aetna "had" the lowest cost ratio among similar large publicly traded health plans according to Beth Senko, an analyst for Williams Capital, but the uptick in the ratio was troubling.


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However, that is not the point. A couple points of margin, weaker than expected guidance or record results that were less than expected was all that was needed to produce massive losses in those guilty of the earnings sin. Stocks were simply priced to perfection and investors are jittery given the failure of the markets to move higher and the approaching summer doldrums. Microsoft missed estimates and was sacked for a -$3.10 loss on Friday. That cost them -$31 billion in market cap, -$3 billion to Gates alone and was the biggest percentage loss since 2000. The drop to $24 was a new $52 week low. That puts them in the same doghouse as Intel although Intel rallied +1.50 for the week on the various press releases about restructuring and rebranding.

Stocks were also unable to move higher despite a -$5 drop in crude. The transports, which normally show the biggest inverse correlation to crude prices, fell -100 points over the week while oil was getting blasted. Why? Because investors were taking profits in stocks like FDX, UPS, BNI, NSC and UNP. For instance Union Pacific beat the street by 8 cents and more than doubled their earnings for the quarter but suffered a -$6 loss before the week was out. This does not mean UNP is a crappy company. It just means investors are taking profits after a successful run ahead of the summer doldrums. Personally the UNP chart looks good to me with the dip taking it back to decent uptrend support. $85 would be better but that is another topic.

Chart of UNP - Daily

What I am trying to communicate today is not that the markets are overpriced or stocks are not a good investment. It is simply time for a pause ahead of summer. We had a good run and funds are rotating out of the winners and it looks like quite are few are going into bonds for a safe place to wait for the October dip. Bonds moving higher pushes the yield lower.

Chart of 10-year note yield

There are other problems in the economy that are not so readily apparent. The dollar is falling like a rock. A cheaper dollar can/will cause a lot of problems despite the canned dollar commentary from Treasury Secretary John Snow. The dollar is falling for various reasons including fear of war with Iran, the deficit and worries about future inflation. The Bernanke testimony this week knocked the bottom out of the dollar with a -150 basis point drop since Thursday morning to an 11 month low. It appears there are fears that the Fed is going to stop the rate hikes just as energy prices are going through the roof. Energy inflation has not yet filtered through the economy into finished goods but it would be hard to imagine it not showing up soon. A cheaper dollar raises the cost of commodities like oil, gasoline and gold. To prove my point gold soared +$18 on Friday to a new all time high at $658. The gold bugs are positively giddy with talk of $800 or even $1000 before year-end. Gold is also a hedge against inflation and OPEC countries are known to buy gold with their petrodollars to hedge against the next economic cycle. With Iran heating up I am sure there is even more incentive to be in a hard currency.

Chart of Dollar Index - Daily

Gold futures chart - Daily

Gold was not the only metal soaring on Friday. The new silver ETF (SLV) began trading and volume was brisk at 2.34 million shares. The ETF represents 10 ounces of silver and closed at $138.16 on Friday. The trust claims the initial basket of silver would be 500,000 ounces and additional baskets of 50,000 ounces would be added as needed. Friday's close equates to $13.81 per ounce and is just shy of the $14.84 contract high seen last week. This is the highest level seen since 1983. Bunker Hunt must be seriously frustrated to see silver gain this stature. He and brother William Herbert Hunt conspired to corner the silver market in the late 1970s and started accumulating silver at $1.95 an ounce. By 1979 the price had risen to $5 and peaked in 1980 at $49.45. They amassed more than 200 million ounces, which was equivalent to half the worlds supply. After they cornered the market the authorities finally woke up and moved against them. The COMEX raised the margin requirements and the Federal Reserve began to squeeze the Hunts and liquidity quickly dried up. The run quickly came to an end on what became known as silver Thursday, March 28th, 1980. Silver already well off its highs fell from $21.62 to $10.80 in one day after the Hunts failed to raise enough capital to stave off the margin calls. Both brothers declared bankruptcy with $2.5 billion in liabilities and only $1.5B in assets. Bunker was finally convicted in 1988 for conspiracy for his role in the scheme. Finally silver has risen from the dead after languishing in the low single digits for over 20 years. That is probably more than you wanted to know about silver but I was working for a man in the silver business at the time and it was how I got hooked on commodity trading. The entire episode was very real to me as we lived it every day.

If you thought I was going to make it though the entire commentary without updating the oil story you were nearly right. There is little to tell other than rehashing the current situation. The report on Iran was presented to the UN on Friday and while it did not contain a smoking gun it was only because Iran has hidden it and won't tell the inspectors where it is. After the obligatory comments from President Bush and several other officials the biggest news came from Iran. Iranian President Mahmoud Ahmadinejad was defiant, saying that whatever resolution the Security Council adopts, it cannot make Iran give up its nuclear program. "The Iranian nation won't give a damn about such useless resolutions," he told a cheering crowd in northwestern Iran. The report said that uranium enrichment is still ongoing and that 120 tons had been converted in the past eight months. If it was used for weapons it is enough to make 15 bombs. It is thought that the UN will now press for a resolution giving Iran a short time to cease enrichment or face sanctions. The last 30 days was an unofficial time out while diplomacy was tried. Since it did not work the next time frame is likely to be shorter and followed by sanctions. Those sanctions could include such measures as freezing Iranian assets and banning overseas travel by its top officials. Iran has been moving assets out of overseas locations for the past two months in anticipation of sanctions. Iran has indicated they plan to ignore any rules placed on them by the UN. They are also talking about withdrawing from the Nuclear Proliferation Treaty. On Friday Iran signed up more volunteers to be martyrs against the United States.

Iran claims daily that they will not use the oil card in their battle with the UN. However, most analysts feel their daily mention is actually a blatant warning that they will not be afraid to use it. They have already demonstrated for the press their new antiship weapons capability and continue to stress they are not afraid of the US warships in the Straits of Hormuz. By continuing to make that claim they are warning that they "could" close the straits at any time to civilian traffic. The straits are very narrow with a one-mile channel in each direction that provides 25% of the world's oil. In military terms a mile wide channel is barely a puddle. Just warning that any tankers moving through the straits could be attacked would be enough to slow down deliveries substantially. A single attack on any vessel would effectively close the straits for weeks out of fear while the various coalition countries positioned themselves to defend it. According to OPEC $15 of the current price of crude is due to the Iranian premium. Once the first shot is fired that premium could double overnight. As the Iran matter continues to wind its way through the UN process the price of oil should not fall far.

Straits of Hormuz with Iran on the top.

Oil closed at $71.85 on Friday after spending two days just over support at $70.50. $70 should be decent support and on every dip I noticed quite a few bids hoping to get filled near that level. Should $70 break on a lack of Iranian news the next support should be in the $67-$68 range. Typically oil and gas prices run up ahead of Memorial Day in anticipation of the summer driving season and growing gasoline demand. Having several refineries still offline or operating on less than full capacity has accelerated the problem this year. Refinery utilization did jump from 86.2% to 88.2% over the last week as maintenance cycles come to an end. Having 335,000 bpd still offline in the Gulf does not help either. 87 platforms are still unmanned. I am still in buy the dip mode and will continue to do that until conditions change.

Crude Futures Chart - Daily

SPX Chart - 90 min

Nasdaq Chart - 210 min

For the next week Dow 11410 appears to be resistance but the Dow is the only index flirting with its current highs other than the NYSE Composite. The Nasdaq is suffering under the weight of several tech disasters and support at 2300 is of far more importance than potential resistance at 2365. The Nasdaq just can't find any traction and lost -22 points on Friday to close at 2321. The SPX, my index of choice, is still captive to our 1310 line in the sand. Resistance at 1315 is several years old and still solid. Support is well below at 1295. My recommendations are still to remain short under 1310. While the Russell small caps failed to rally all week they did hold their ground at 765 with 760 as critical support. The NYSE composite did manage to set a new high on Friday on the strength in the financials and is doing an amazing job of holding the high ground. The decline in the energy stocks on Thursday managed to force a break of the 8400 support level but the dip was bought almost immediately when traders moved into financials after the Bernanke testimony.

The NYSE Composite is the fly in my bearish soup. If the NYA was showing any of the weakness shown in the other indexes I would be pounding the table to go short. Instead it is standing out in the crowd as the sole beacon of bullish enthusiasm. This relative strength makes the NYA our confirmation indicator. Go short on an SPX drop below 1310 but remain cautious. Should the NYA break support at 8400 then back up the truck.

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