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Were You Expecting a Rally?

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I hope readers were not expecting a post Fed rally because I have done my best over the last three weeks to warn that storm clouds were growing a post Fed drop was highly probable. You will probably read in the newspapers of hear a sound bite on the news that the market tanked for any number of reasons. Some are saying high interest rates, others declining consumer confidence, rising gasoline prices or fear the economy will grow too slowly. Others will say the economy is growing too strongly or earnings were not strong enough. The Fed will be the number one excuse de jour with their last 25-point hike and/or the vague language in the statement. There are dozens of excuses being used this weekend but all but one of them are wrong. They may be contributing factors but the primary cause is simply what I have been telling you for the last several weeks. The market was priced to perfection. The bull has run a good race but even prize bulls are eventually slaughtered. What we don't know is whether this is the start of something big or just a quick retracement before another leg higher. What we do know is that the current bull market has lasted nearly 800 days since a normal -10% correction. That is the third longest streak in modern times and like any streak it will eventually be broken. If Wednesday's high was the break high then the current streak has lasted 798 days.

Top Five Streaks Without a 10% Correction

The Q1 earnings are over and those released last week were less than stellar. Dell and Cisco head the list but there were plenty of others with weak guidance. This weak guidance should not be a surprise to anyone. The second half of 2006 has been expected to show a decline in earnings for more than a year now. The guidance in the Q1 earnings was actually stronger than analysts expected but it still pointed to a cooling of profits and the economy. Earnings are great but the comparisons will continue to get harder as the year progresses. It is not a problem, companies will still be highly profitable but the pace of growth will slow. That also assumes the economy continues to grow steady as well. None of this had any material impact on the market drop. The Dell and Cisco earnings may have helped get the ball moving but the Nasdaq was already on shaky ground.

The analysts and broadcasters on CNBC were consumed with talking about the bursting bubble in metals and energy and completely overlooked the coming option expiration. Anyone using options to capture the Q1 earnings gains was faced with an expiration of the earnings cycle as well as the expiration of May options. It was simply time to take profits. Funds using options to enhance their returns and the thousands of hedge funds who leverage themselves to the moon with options almost ALWAYS exit those positions late in the week before expiration week. That should be no surprise to anyone. Years ago they would wait until expiration week but that changed early this decade. We have had two dozen quarterly expiration cycles since the 2000 crash so the timing of option exits for funds should not be a surprise to anyone. Since it only happens four times a year in volume it is often overlooked as a contributing factor to market performance.

I warned readers over the last three weeks that there was trouble ahead. The monster short squeeze the preceding Friday on the benign jobs report was a hiccup in the aging process for Q1 earnings cycle because the majority of professional traders were already setting up for the drop. It was only a temporary setback and they were forced to reload their shorts at a higher level. The timing of the FOMC meeting was an added plus.

Combination of reasons blamed for the market drop:

1. End of Q1 earnings cycle, future earnings slowing
2. Massive profits to protect
3. Post earnings cycle option expiration
4. Fed announcement was already priced into market
5. Fed announcement was less clear than expected
6. Transport spike +250 points over support
7. Record oil prices near end of expiration cycle
8. Gold, copper, silver, palladium, etc at 25yr highs
9. Arrival of summer doldrums period
10.Third longest bullish streak in 50 years

While all of those factors listed above contributed to the drop it was simply time to take profits. You may have noticed I did not say anything about rising inflation. The talking heads on TV were putting the "rising inflation" phrase in nearly every sentence as though it was the holy grail of reporter credibility. While inflation may be a problem eventually it had nothing to do with the drop over the last two days. Repeat after me, Profit Taking, Profit Taking, Profit Taking.

There were signs of inflation in the Import/Export Prices report on Friday but it was primarily due to the surge in energy prices. Import prices rose +2.1% to end a streak of two consecutive down months. The jump was more than consensus estimates for a +1.0% gain. Export prices also rose +0.6%. The jump in import prices was primarily due to a jump in oil products of +11.5%. This was the biggest jump in imported energy prices since the +13.4% jump in March 2005. The jump was also powered by a rise in metals prices and a price hike on imported autos. The Fed will be worried about a pass through of energy prices contributing to inflation but to date it has not shown up on the consumer side.

The trade deficit for March shrank unexpectedly to $62 billion compared to $65.6B in February and estimates of $66B by analysts. However, our deficit with our currency manipulating trading partner, China, rose from $13.8 billion to $15.6 billion. I am sure Treasury Secretary Snow was cursing under his breath knowing this would produce an entirely new round of questions about their currency problems. The U.S. Treasury reported last week that China had made "far too little progress in introducing rate flexibility." In english that means they are keeping it low to make their products more attractive to U.S. consumers. Analysts think the yuan is undervalued by 40% or more making their products very cheap and aggravating the deficit problems.

The most depressing report on Friday was an extremely large drop in consumer sentiment. The headline number fell to 79.0 from 87.4 or -8.4 points. The slide was led by a drop in the present conditions component from 109.2 to 96.2. This -13 point drop was the largest monthly drop on record. The expectations component also declined from 73.4 to 68.0. Since the stock market was up for the period covered in the report most analysts feel it was the constant whining about gasoline prices that poisoned consumer sentiment. If you remember over the last two weeks we had gasoline prices around $3 and shortages in several areas as the MTBE/Ethanol conversion began. Talking heads on the network news shows were obsessed over the price of gasoline during a non-crisis period. Speculations about the coming hurricane season and higher prices during the summer vacation season had every politician within reach of a microphone making a speech. Consumers already pinched by falling housing prices, higher credit card payments and rising interest rates were feeling the pain at the pump. This report should give the Fed an additional reason to take a pass at the June meeting.

The economic calendar picks up again next week with several reports on housing, PPI, CPI, Industrial Production, several Fed business surveys as well as the Semi book-to-bill report. All will be dissected to see if they fall into the guidelines required to keep the Fed on hold. While these will keep market reporters busy they should not have any material impact on the indexes unless there is a major consensus miss.

What may cause trouble is news reported after the market close on Friday that IAEA inspectors had found uranium enriched to 90% at a site in Iran. Uranium only needs to be enriched to 5% for electrical generation and 90% is bomb grade material. Enriching to 90% requires substantially more effort than the simple reactor fuel they claim they are producing. The site, a weapons research facility at Lavizan, was reported by an informant as an undercover nuclear research site several years ago. When the IAEA arrived to examine it the entire site, consisting of a block of substantial buildings, had been bulldozed with even the topsoil removed. The IAEA took environmental samples from the surrounding area. They later tested some equipment that reportedly was moved from the building to another location. Those samples tested positive for the highly enriched uranium. The times, dates and method of collection are still fuzzy since the story just broke. However, a quick Google of the keywords produced hundreds of pages relating to the swift removal of the site once the IAEA told Iran they were going to investigate it. Muhammad el-Baradei, head of the IAEA, reported the intelligence and the destruction of the site to the UN in late 2004. The discovery on the relocated equipment was just disclosed on Friday. This site and its sudden removal was featured on the Discovery channel documentary they are currently running called, "Is Iran the New Iraq?" Check your listings. They had some very clear satellite pictures of the site before and after the removal. It is very hard to decipher the reality from the propaganda due to the highly charged atmosphere surrounding the Iranian nuclear problem. This may be old data with a new spin, disinformation or propaganda designed to keep the pressure on Iran within the global press. Since the uranium traces, which had been enriched to weapons grade strength, were found at a weapons research installation only hikes the importance and the inflammability of the news.

Oil prices fell on Friday partly on statements from the Iranian president that Iran would comply with any valid restrictions that were in line with international rules. He did not say of course that Iran would decide how the rules applied. While this received a lot of press there was also comments from him that Iran was not afraid of possible military action by the U.S. because of Iran's military strength. He also said "the U.S. is trying to frighten Iran by waging a propaganda war using strong words but Iran was not afraid." Mahmoud Ahmadinejad was called the man of the year as he spoke to more than 1000 cheering students in Jakarta Indonesia on Friday.

The U.N. committee putting together the carrot and sticks resolution said it could be another week before it is ready for a vote. Mahmoud said he was not interested in any UN bribes to halt the research. UN Secretary General, Kofi Annan, called on the U.S. to negotiate directly with Iran saying Iran would never negotiate with the UN alone. The U.S. State Dept rejected Annan's appeal saying it was simply another delaying tactic and that the confrontation was not with the U.S. alone but with the world. The next committee meeting is May-19th to discuss a new package of incentives as well as penalties if Iran does not comply. French President Jacques Chirac said Europe should seek the imposition of UN Security Decisions on Iran due to growing concerns. What? A backbone from a French politician?

Oil prices probably fell more from a result of options expiration than from any Iran news. Even a pipeline explosion in Nigeria that killed as many as 200 people failed to produce any bounce in oil prices. It turned out to be a gasoline pipeline that vandals had dug up. They drilled holes in the pipeline to siphon out gasoline to sell to willing buyers. A spark ignited an explosion that incinerated everything within a 20 yard radius and produced severe burns for another 50 yards. Over 150 corpses, some turned into ash were visible near the pipeline but eyewitnesses said many more were blown into a large nearby creek. Rescue workers used makeshift stretchers to carry the remains to a shallow grave dug a short distance away. Nigerian authorities said it was not related to the rebel attacks that have cut production by 20% over the last several months. Some oil workers taken hostage earlier in the week were released unharmed.

For a Friday the oil scene was fairly calm. Prices declined from the $73 level on pre expiration activity to close at $72. I would be surprised if we do not see a rebound in crude early next week. The oil inventory report we got Wednesday showed that crude levels had risen only +300,000 barrels but gasoline had risen +2.3 million bbls. This depressed prices temporarily until traders realized that gasoline demand had rebounded from the prior week to the high for the year at 9.346 million barrels despite the high prices. Since this was the numbers for the first week of May I decided to do some research so we can track the demand growth from May-1st through the July-4th weekend. This is when demand spikes as Memorial Day kicks off the summer driving season followed by a peak around July 4th. The table below shows the historic demand since 1991 for the 9-week period beginning with the first reporting week in May. I added the average gasoline price for that period to illustrate the recent change and its impact on demand. As you can see from the table there was almost no discernable impact. Demand continued to increase despite a nearly +300% increase in prices. I will continue to update this table each week until the period expires. If demand continues to rise through May I expect crude prices to follow.

Gasoline Demand Table

The EIA restated their demand growth targets for 2006, again. They are now targeting demand growth of crude oil of +1.25 million barrels per day for all of 2006. This was down slightly from their last upward revision to +1.47 mb of growth. They cited a -10% drop in gas/diesel demand in Germany and a lower than expected demand from China for April. Since the IMF raised their growth targets last week for China to +9.5% for all of 2006 I expect the next EIA revision to be higher. Another survey I saw expects China to continue growing by the +10.2% rate we saw in Q1. China now has 23 million autos and that is double the number they had in 2003. While China has taken steps to slow the growth of automobiles they are still adding between 6-8 million per year. Add that to our +16 million in the U.S. and it will take a few more dinosaurs to fill the tanks. Actually that is only a figure of speech since oil is derived from plant material not animal.

Other oil related events include the nationalism fight in Bolivia. Evo Morales had to rethink his "agree or leave" mandate for the major energy companies in Bolivia. He found some stout opposition from most and Petrobras told him to take their $1.5 billion prior investment and stick it where the sun doesn't shine. After a hurried flurry of meetings and consultations Bolivia said they would compensate everyone for the confiscated property. That appeased everyone for about a day until Morales changed it to "we are not obligated to compensate anyone who has already received enough to energy to cover their initial investment" and from the tone Bolivia would manage the accounting to make sure it included everyone. Morales then accused Petrobras again of operating in the country illegally. Morales then proposed a 60% hike in gas prices to Brazil to quiet the state owned Petrobras. With Brazil consuming two-thirds of the gas exported by Petrobras from Bolivia a 60% hike would be a disaster. Morales raised the stakes and Brazil can't afford to call. As of press time on Friday it was still a stalemate and one that Brazil/Petrobras may not win. Other companies affected were Repsol YPF, Total, BP and BG Group. To reward Morales for his leftist nationalism decision Venezuela's Hugo Chavez provided Bolivia with a credit line of $100 million and a promise to donate $35 million for computers in Bolivian schools.


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Chavez also announced he was pulling out of the Andean Trade Community because fellow members Peru, Columbia and Ecuador were signing free trade deals with the United States. He asked Morales to join him in the revolt. Both leaders were attending a summit of European and Latin American leaders in Vienna. Together they received stern rebukes from nearly every speaker for their restrictive stand. Chavez is now targeting the heavy oil producers of the Orinoco River basin in Venezuela. The majors lifting oil there include Chevron, Exxon, Statoil, Shell, Conoco, ENI and others. They would be forced to turn over 60% of their business to Venezuela effectively giving the state total control. The government also moved to add a 33% extraction tax in addition to the 50% income tax already in place. They also added a +1% export tax. Needless to say the future of energy production from Venezuela and Bolivia is looking grim. According to Dow Jones exploration companies in Venezuela quit drilling in advance of the nationalism play and production is now -7.8% below last years levels. Bloomberg reported that the lack of new investment by the majors was forcing PDVSA, the Venezuela state owned oil company to seek up to $20 billion in loans from international banks to increase production. Would you lend a billion to Venezuela given their recent disregard for formal contracts? I doubt it. PDVSA also said it was going to look to its partners for another $20 billion. I am sure its partners, XOM, TOT, ENI, COP and CHV can't wait for that phone call. Meanwhile Venezuela subsidizes gasoline for its citizens providing it to them at the equivalent of 12 cents per gallon. This is how Chavez maintains control over the voting public. Not that votes actually count. Attempts in the past to raise gasoline prices have met with significant amounts of social unrest. Chavez is now trying to pass a referendum to allow him to retain his position until 2031. Fortunately the world is a big place and we can afford to look elsewhere for trading opportunities while the bullies destroy their sandbox.

I read an article on Bloomberg last week discussing China's voracious appetite for commodities of any flavor. China's State Reserve Bureau said it was going to step up acquisition of critical commodities to avoid any future shortages. With the Olympics in 2008 and the Shanghai World Expo in 2010 they are on a monster building binge. They expect 1000 new skyscrapers to be built between now and 2010. That is in addition to the more than 4000 that currently exist. China's economy grew by +10.2% in Q1 and China Daily said last week the economy is expected to grow by +8% annually through 2010. That is a monster growth rate in a country of more than a billion people. To fuel this growth the Reserve Bureau said it was going to increase reserves of iron by 5 billion metric tons, copper by 20 million tons and bauxite (aluminum ore) by 200 million tons by 2010. They are planning 2-3 additional strategic petroleum reserves of up to 5 billion metric tons each as well as 100 billion tons of coal. Since a metric ton of oil equals 7.3 bbls that would be 36.5 billion barrels per reserve or 429 days of total global output. I think somebody got their decimal point in the wrong place and meant 5 million tons or 36.5 million bbls. Still a lot of oil when you add three reserves to the one they have not yet filled. Longer term they are adding over 50 and as many as 100 nuclear power plants and more than 300 coal fired electric plants. More than 80% of China has no electricity for much of the day due to power shortages. They just signed a deal with Australia for $71.4 billion in uranium ore for initial deliveries to begin as their plants begin to come online within four years. I am telling you this now because I want you to be in the front of the line as China tries to acquire these commodities. This is a buying spree unknown in modern history and the end result is going to be much higher prices for everything. Almost any oil stock will benefit because that big sucking sound is oil heading for the Chinese market. See the LEAPS Trader newsletter this weekend for my favorite China energy play. I also like the mining stocks BHP, PCU, CCJ, RIO and GG for the continued bounce in gold.

Without looking at the table below I am sure everyone agrees the week was a disaster. Actually the losses for the week were almost all generated after Wednesday's open. That means those loss percentages represent roughly three days of trading not five. To say the selling was sharp would be an understatement.

Table of percentage losses for Friday and the week.

The damage done over the last three days was substantial. As you can see from the table below the change in the internals compared to the Thr/Fri from the prior week was very negative. Thursday's down volume was 6:1 over up volume and Friday's was only slightly better at 5:1. The new highs plummeted from 802 on the monster jobs related Friday short squeeze to only 104 a week later. The severity of the selling suggests it will be short lived.

Table of internals for last seven days

I am sure you heard all the statistics from the news sources like worst two days for the S&P since October, worst two-day drop on the Nasdaq since March 2005 or NDX low for the year. There were plenty more being tossed about but I know you get the picture. Now that the bull barbeque is in full bloom the real question we all want to know is when will it stop?

I am betting we should get a bounce very soon. While we are likely to see some margin call selling on Monday we are resting on strong support on most of the indexes. There was some bottom fishing late Friday but the few dip buyers taking the risk early were steamrolled into the close. The pre expiration option volume was simply too strong. Sell stops trigger selling and that triggers even more sell stops. When you get a day like Thr/Fri it is best to wait for clear signs of daylight before pulling the entry trigger.

The Russell and the NYSE Composite have been the most bullish of the broader averages coming into the week. The NYSE Composite fell to just above support at 8400 at the close and a decent spot for bottom fishing. If that level breaks the next material support would be 8200. The Russell 2000 declined to 742 and halted its decline exactly at support from early April. A break of 740 could target 720 as the next stop.

Chart of Russell-2000 - 60 min

Chart of NYSE Composite - 30 min

The Dow retraced nearly -300 points from Wednesday's six-year high at 11670 to close in congestion at 11379. The initial support at 11450 held for about two hours before collapsing on losses in CAT, XOM, AA, BA, MO and UTX. Meanwhile AIG, DIS, AXP and GM were the only Dow components to finish in the green. Considering the -$4 drop in AIG on Thursday the fractional gain on Friday was not even a respectable dead cat bounce. The Dow support at 11365 might contain any margin selling on Monday but a break there would indicate the fire drill is not over and the next target would be 11275. A normal -10% correction would take us well below that to 10500. While I can't imagine that in the near future that is the -10% level.

The Nasdaq went into free fall beginning with Dell's earnings warning and never looked back. The plunge past initial support at 2300 did not even merit a pause. Friday's close at 2243 is at what I would consider as very decent support for all of 2006. A break here targets 2190 and the low for the year. A normal -10% correction from the 2375 double top high in April would take us to 2137 but I believe a break under 2190 could spell trouble and a possible drop to retest the October low at 2025. I know it sounds grim and I don't expect that to happen but that is the risk.

Dow Chart - 30 min

Nasdaq Chart - 120 min

Dow Transport Chart - 120 min

I highlighted the Dow Transports last Tuesday as extremely overbought and most likely to correct. They did it in high style with a triple digit loss on Friday to close at 4840 and -172 points off the Wednesday historic high at 5013. That was only a -3.45% drop and a full-blown correction would take them to 4512 and -500 points off the high. I do not expect this to happen. Nothing in the market or the economy suggests any weakness in shipping and I believe the other indexes will bottom first and rescue the transports from a dismal plunge. The transports could retrace to 4700 and still remain in the current up trend.

Earlier I mentioned the current bull run is the third longest in recent history dating back to 1950. While it will eventually break that streak there is nothing that says it has to be now. I also mentioned above that I believe profit taking and funds closing option positions ahead of next week's expiration cycle is what produced the damage. I do expect the dip to be bought and I backed up the truck at Friday's close just in case. The simultaneous arrival at support on multiple indexes was enough for me to take a position ahead of any dead cat bounce on Monday. Most were positions in energy and metals that had already taken a major hit. Just because I took the chance does not mean I won't be hung out to dry on Monday if this plunge is not over. I simply calculated the risk with multiple indexes at support and took it.

I personally don't believe we are going for the full -10% correction although the Nasdaq Comp, Nasdaq-100, SOX and Russell are already more than -5% off their highs. Also, even if we are going to go for the full -10% it is inconceivable that it would happen all at once. Rarely do full corrections happen in a week. Two to three weeks maybe but normally it is a process that unwinds over several weeks with multiple bouts of dip buying followed by failed bounces. I calculated the levels for a -5% drop and a full -10% drop and compared it to Friday's close in the table below. I used the recent highs as the starting point. You can see the blue chips as evidenced by the Dow and S&P-100 held up the best while the SOX has nearly completed a -10% drop.

Table of percentage drops from recent highs

For next week I would look to buy a bounce over SPX 1295 but only for a short-term trade. Once any margin selling at Monday's open is over I would expect the current oversold conditions to ease. However, we still have a large number of retail traders who are probably still nursing some May option positions. While that is a far less damaging market force it could weaken any bounce. I believe the current underlying bullishness will return and it will be a fight to produce any new order imbalances either up or down. It is more likely that we enter a range bound period where positions are shuffled and traders setup for the summer doldrums. I believe the worst is over but as we all know the market sometimes gets caught up in its own momentum and overshoots the obvious targets. I would look to be long energy and metals as the only safe bets for the next month. Safe may be relative but that is where I plan on hiding. Keep tight stops on any dip buys and be ready to step aside if the power selling resumes.

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