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Market Wrap

Short, Sharp and Scary

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They say bull market corrections can be short, sharp and scary. This has been the case for the markets since the May 10th FOMC meeting. The commodity markets have posted losses even more dramatic than most equities and this has been reflected in those stocks. Some individual materials stocks have seen declines of -15% to as much as -30%. That is extremely scary for holders of those issues. Gold hit a high of $732.50 the morning after the FOMC meeting but has declined -11.8% to Friday's close of 657.50. Copper, in a major bull market that has seen a +100% rally since Jan-1st saw a drop from last weeks high of 4.01 to 3.45 intraday on Friday for a decline of -14%. Copper started the year at $1.95 a pound and rose to $4.01 the day after the FOMC meeting. For those who were riding the gains since the rally began last year or even just since mid March at $2.35 the -14% drop was just a hiccup. For those late to the party it was an ugly event with copper stocks taking much more severe hits. Phelps Dodge fell -20% in the last seven days. Southern Copper (PCU) fell -29% over the same period.

The commodity drop combined with the drop in the broader markets produced some serious pain for investors and only a last minute rebound on Friday prevented a 22-year streak from being matched on the Nasdaq. The Nasdaq had fallen for eight consecutive days through Thursday to equal the consecutive day loss streak last seen in 1994. Had Friday also ended with a loss that nine-day losing streak would have taken us back to 1984 to match it. That is 22 years for those of us who are mathematically challenged. The Nasdaq has dropped farther in shorter periods of time but not since 1984 has it dropped nine days straight. The CRB commodity index fell -25 points to 340 intraday on Friday from its 365+ high on May-11th. This was the largest weekly loss for the CRB in 25 years.

The commodity sell off was being attributed to the unwinding of a hedge trade by several large hedge funds. Reportedly hedge funds had shorted bonds on their fall from the Jan-18th high and used the proceeds to go long commodities. The yield had risen from 4.289% at the January to 5.192% last week after four months of heavy selling. When the Fed appeared to be saying it was going to halt the rate hikes and the inflation numbers took a sudden spike higher bonds were suddenly a safe haven again. With the surge in bond buying the funds raced to sell commodities and cover their bond shorts. While the CRB was falling -7% this week the bond yields fell -3.2% as investors bought back those bonds. Bond buying pushes yields lower. The intraday yield low on the ten-year note was 5.024% compared to the 5.192% high the day after the FOMC meeting. In bond terms this was a major move and took yields back to levels not seen since April 25th. Fedspeak from several Fed heads last week seemed to indicate they might be targeting commodities to reduce inflation pressure. This added to the commodity demise. In the 1980s the Fed targeted speculation in real estate, the 1990s they attacked the speculation in emerging markets and in 2000 they raised rates to 6.25% to burst the Nasdaq bubble. In 2005 they put their sights on the housing bubble and Greenspan pronounced it dead on Thursday night. Now with energy and metals pushing inflation higher some feel the Fed is going to focus its power on crushing commodity speculation and therefore prices on energy and critical metals like copper. Bottom line, with some speculating the Fed could raise as much as +50 points in June, rather than the pass everyone expected just a week ago, it strikes fear in the hearts of highly leveraged hedge funds.

Sharp? Yes. Scary? You bet. Short? That is yet to be seen. The rebound on Friday was a struggle when the morning dip was followed by a small bottom fishing rebound that had no legs. As the afternoon wound down they tried to sell them off once again as has been the pattern all week but another bout of short covering and position squaring brought the indexes back into positive territory just before the close. It was hardly a bullish end to a highly bearish week. Missing was the high volume rebound as traders rushed to pickup bargains. Also missing was the "V" bottom rebound investors are used to seeing after a major market dip. Friday's volume was extreme at better than 6.3 billion shares but the internals were nearly flat. Much of the volume was due more to options expiration than buyers returning to the market. There was evidence of bargain hunting but it was weak.

The Nasdaq rebounded +13 points but it was a very narrow gain. Only a couple sectors contributed to the move and it was related to the Dell decision to begin using AMD chips in its servers. The SOX jumped +15 points, more than the Nasdaq, due primarily to the +3.60 jump in AMD. This more than offset the -29 cents decline in Intel. Dell rallied +62 cents. The Semi Book-to-Bill released on Thursday night showed that growth in orders exceeded that of shipments in April. The BTB rose to 1.11 from the 1.03 posted in March. That represents $111 in new orders were received for every $100 shipped. This was the highest level since April-2004 and the largest monthly increase since Dec-2003. The BTB contributed to the strong gains in the SOX. According to SEMI orders are now +60% over cyclical lows seen in 2005 when the BTB was only 0.77. This is the kind of news investors were waiting for and some brave souls actually snacked on chip stocks on Friday after a -11.46% correction from the recent highs.

Much of the Nasdaq thunder this week was stolen by weakness in stocks under suspicion for backdating option incentives for executives. Safenet (SFNT) -4.28 and (Juniper (JNPR) -1.04 led the list but other Nasdaq stocks surfaced as potential losers as well. VTSS, BRCM, FFIV, MEDX, DPTR and CNET are under suspicion as well. On the NYSE United Health (UNH), Affiliated Computer (ACS) and Caremark (CMX -3.34) were tagged as under investigation. This list will undoubtedly grow larger and it is being touted as the market scandal of the year. We are just getting over the accounting scandals from several years ago that prompted the passage of Sarbanes-Oxley reform bill. Prosecution of the current option scandal is said to be a slam-dunk since the clear and public paper trail required for the option process is going to be used as evidence against these companies. This is only going to build as the weeks pass and many companies will be tarred and feathered in the market place that did nothing wrong until the suspicions are erased. This could be the thorn in the Nasdaq side for weeks to come.

Oil prices imploded from $73.90 on May 11th to support at $68 a drop of -8%. There was no material change in demand despite what some talking heads were reporting. There was also no material change in supply and there was a drop in refinery utilization. The only event that produced this decline was profit taking and the rotation out of leveraged positions by some large hedge funds. Chavez did say he was thinking about pricing his oil in euros as just one more way to aggravate the United States. Iran made comments all week about ignoring the UN but started making conciliatory sounds on Friday after the EU offered to help Iran build several light-water nuclear reactors and setup a fuel bank if Tehran will stop its nuclear program. Reportedly the EU had also gotten permission from the US to offer them new civilian aircraft, which they need desperately. They can't buy them on the open market due to sanctions stemming from the 1979 hostage crisis. That may be the icing on the cake for the agreement. However, there is a clause in the agreement guaranteeing Iran they will not be attacked in the future. This is the get out of jail free card and understandably the US is against this guarantee. Everyone knows Iran will continue its research on some scale in top secret installations but they are willing to wink and look away if Iran will at least say they have stopped. If they are found to be conducting experiments on a bomb at some point in the future the US wants the ability to take corrective offensive action. I don't know how this will work out over the next week but the fact the parties are talking is removing some of the Iran premium from the market.

Gasoline demand chart for last week

Natural gas was crushed after the gas inventory report on Thursday showed a +91 BCF build instead of the +85 BCF expected. Gas inventories are now +53% above the five-year average. Total gas in storage is now more than 2 trillion cubic feet and a record for this time of year. It is simply a matter of a winter that was much warmer than normal and a spring that has been blessed with mild weather. That is assuming you don't live in Texas or Arizona. Triple digit temperatures are already making an appearance. I heard one forecaster saying that Phoenix had the potential this year to break its record of 145 triple digit days in one summer. Dang, that is hot! The excess gas has pushed prices under $6 and a new 52-week low. However, it is a highly seasonal commodity and once that warm weather starts moving farther north those supplies will begin to fall. The trouble with cheap gas from an investor perspective is the impact on coal. Coal is the other fuel that generates much of our electricity. When the price of gas on a BTU level falls in relation to coal it causes the price of coal stocks to fall as well. If gas is cheap electric companies will use it instead of coal when possible because of the lower emissions. The actual coal price does not decline but coal stocks do. Coal is typically sold far in advance of its production, years in many cases. Power companies contract well in advance to lock in prices but many companies have both coal and gas facilities. Coal plants will be used for backup power whenever possible while their clean burning gas cousins toil away producing electricity at maximum levels to combat the heat. The coal will continue to pile up in storage for later use. This scenario has knocked the blocks out from under BTU, ACI, CNX and MEE. While I want to buy the dip it would not be advisable unless you have a long-term outlook until gas prices begin to firm.

Greenspan was uncharacteristically frank in his speech on Thursday night as he covered several topics of interest. He said the Fed had killed the housing bubble, which is no surprise to those in the areas with the biggest recent gains. Homes are flooding to market as speculators abandon ship. For instance, the Phoenix market had 4,500 homes for sale four months ago. That number has risen to 45,000 today. An avid subscriber in Phoenix normally emails me a couple times a month. I have not heard from her recently because I expect she is really busy. The foreclosure rate nationwide actually dipped -10% in April from March levels but was still +33% over levels seen in April 2005. 91,168 new properties were added to the pending foreclosure rolls in April. Colorado continued to hold on to the top foreclosure rate despite a -31% decline from March. The lowered April level was still +43% higher than April 2005. Texas accounted for 15% of all new foreclosure activity nationwide. This was the fifth consecutive month Texas held the top spot. California was second followed by Florida.


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Greenspan warned that consumers would have a lot less money to spend now that loan standards had been raised and the access to home equity was shrinking. He warned that this could have a negative impact on the economy in the latter half of 2006. He also cautioned that the impact of higher energy prices had yet to be seen given the falling buying power of consumers. He then took on the derivatives business calling the failure to clean up the current antiquated system as "unconscionable." Despite the dramatic growth of the derivative market into the trillions many systems are still processing orders on paper with no standardization. Some brokers relate stories of writing orders on napkins or the back of a restaurant checks or credit card slips. Greenspan has always warned that the derivatives industry was a house of cards on the verge of collapse. Bernanke has pledged to support a clean up as well as discuss new hedge fund changes. He still feels the market is the best disciplining factor for the $1.2 trillion hedge fund business. "The primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors," Bernanke said in a speech to an Atlanta Fed conference on hedge funds at Sea Island, Georgia. He feels the Fed could do more harm than good by imposing new rules but agrees there is a need for better reporting. He did talk down a proposal for a central database of positions as not useful to regulators. Some have advocated this as a way to prevent another Long Term Capital meltdown like we saw in 1998.

Hedge funds pulled in $24 billion in new investment in the first quarter. That investment may have been the primary reason for the surge in commodities that prompted the unsupportable spike. $24 billion in the hands of hedge funds produces 3-5 times that in buying power or even more when it enters the futures markets. They undoubtedly had prior commodity bets and this additional money just added fuel to the fire. In order to capitalize on the profits and capture the management fees they have to turn those positions into a profit by selling them hence the sudden implosion when the bond/commodity trade began to collapse. Add in the expiration of options and futures contracts this Friday, sharply rising inflation in the CPI headline number and we got the perfect storm for the markets.

The scary portion of the correction has been how quickly everything collapsed. From the post Fed meeting opening spike on Thursday May 11th to Friday's lows was only seven trading days. In those seven days several of the commodities fell more than -10% with silver the leader with a -18.68% drop. The SOX was the only index to officially break -10% but several others came within a whisker of nailing a -10% decline. You will note in the table below that the indexes with the largest and most bullish gains, the NYSE Composite, Russel-2000 and the Transports joined both the Nasdaq indexes at the -9% range. The Dow, which had been pushing new six year highs almost daily prior to the Fed has failed to correct meaningfully in the percentage category despite the nearly -600 point drop.

Correction table for major indexes and commodities

I am boring you with the nitpick details of the index drops to make a point. I believe we are close enough to start looking for the end of the selling. The expiration pressures are nearly over and with the Russell and Nasdaq 100 close enough to -10% to reach out and touch it there is little incentive for further selling. Sure, there are probably some sellers remaining but at -10% level the bargain hunters will start coming back in force. Maybe not enough force to start a new rally but at least enough to weaken any further attempts at a meaningful decline. I told you last Sunday I expected a return to a trading range once the drop was over and I still expect that to happen. This is after all May and the sell in May and go away crowd will not be back until summer is over. It may take a few weeks for that range to be defined. Once it is clear the selling has slowed the bulls will probably limp back into the market only to have the sellers reappear once the bounce begins to fade. The short sellers have huge gains and at this point very tight stops. Let a couple good buy programs hit the tape and those stops will be popping faster than corn at the Da Vinci Code opening this weekend. (Fandango.com reported that 78% of all movie tickets being sold this weekend were for the Code.)

A problem facing the markets next week will be a strong IPO schedule. The largest to come to market next week are Vonage at $500 million and MasterCard at $2.8 billion. MasterCard is expected to price in the $40-$43 range for about 66 million shares. MasterCard is a complicated IPO due to a sudden surge in class action suits for alleged price fixing on fees between the major card companies. They also are being sued for restricting competition and blocking member banks from issuing cards of their own. Still, MasterCard is expected to have no trouble extracting $2.8 billion from the equity market. When added to the $500 million Vonage IPO and a couple smaller issues it will amount to a -$3.5 billion market draw. Since the IPO stocks are not in any indexes it is a negative to the current indexes. Hopefully those planning on participating used the selling over the last seven days to raise cash rather than wait until next week.

The economic calendar is dull next week with the only reports of interest being the Richmond and Kansas City Fed surveys, Durable Goods and another look at home sales. The Q1 GDP revision will arrive on Thursday and Personal Income and the revision to Consumer Sentiment on Friday. With the rampant debate on the future of interest rates we are sure to get more Fedspeak to cloudy the waters. After the normal week long quiet period after the FOMC meeting the airwaves were filled with Fed comments on Thursday and Friday. I said cloudy the waters because some of the comments were vague at best with different Fed heads expressing opposing views. Poole said on Thursday that he could not rule out a +50 point hike at the June meeting but he could also not rule out a pass. He said inflation risks were rising but that the decision would be made on the data at the meeting rather than guessing in advance. Jeffery Lacker roiled the markets on Thursday saying a pass in June was less likely with inflation pressures now borderline. The Kansas City Fed President Thomas Hoenig warned that the Fed needed to be reminded of the lags to interest rate changes before making another move. Hoenig said his view was that inflation was set to slow. His personal comfort range is inflation between 1.5% and 2.5% with the current core index at +2.3% and rising. Hoenig is seen to be an inflation hawk and is not currently a voting member. His bank has declined to ask for a hike at the last two meetings and asked for patience to see how the economy was progressing. After the rocky start Bernanke made with seemingly conflicting statements on inflation and the need for further hikes it is now expected he will have to be firm to regain credibility. The Fed funds futures are now pricing in a 62% chance of a hike at the June 20th meeting. Only a week ago that chance had declined to only 35%. JP Morgan is predicting a pause in June but then an increase to 6.0% by year-end. Former Fed governor and senior economic advisor at Schwab, Lyle Gramley, is predicting a hike in June and a pause in August. Bill Gross at Pimco is predicting a stop at the current 5.0%.

Market Internals Table

To wrap up my outlook for the week I would have to say it was positive. Our game plan for the last two weeks was to short a break below SPX 1315 after the FOMC meeting. That worked out well. Last Sunday I suggested buying a rebound over SPX 1295 on volume for a short-term trade only. We never got that rebound with both attempts failing at 1297 and 1296 respectively making good entry points for new shorts when it rolled over. The SPX dropped to 1256 on Friday. That is support from Jan/Feb and the 200-day average. It is also a logical place to stop even though it is only a drop of -5.31%. The SPX had not been as bullish as the other indexes and had lagged back with the Nasdaq as the SPX consolidated in place for much of March and April. This means there was less pent up bullishness in the index that needed to be removed.

All of the charts from last week show an amazing correlation. All crashed through early support levels that had previously held but nearly all ended on decent support once again except for the Nasdaq. The Nasdaq chart is a picture of broken support from the 2300 level through various support points including the 100/200 day averages and all the way back to 2200 where the uptrend support from Oct-2002 was broken. In a word, ugly.

Russell Chart - Daily

NYSE Composite Chart - Daily

SPX Chart - Daily

Dow Transport Chart - Daily

Since the Nasdaq, Russell and NYSE Composite have for all practical purposes already hit the -10% correction level the incentive for further declines should fade. The very strong volume of 5.98B, 5.15B and 6.3B from Wednesday through Friday was cleansing. Wednesday's -214 drop on the Dow, -33 on the Nasdaq produced a 6:1 ratio of down volume to up volume and had all the signs of a capitulation event. Decliners beat advancers 4:1 with only 72 new 52-week highs compared to 431 new lows. All of those numbers improved as the week ended. Friday's volume was nearly 2:1 advancing over declining despite the anemic closing numbers on the indexes. Bargain hunters or should I say bottom fishers were definitely entering the market but the sellers were still making their presence felt. With our potential range over the next several weeks being SPX 1250-1295 there is plenty of room for upside while the downside may be limited. If sellers do return in force and 1250 breaks the outlook becomes VERY bearish. It could be a long drop. Hopefully that will not happen but we always need to be ready for that potential event. My recommendations for next week would be to buy the bottom of that SPX range and be prepared to short the top. Since that is a 45-point range we will probably see several aborted rallies before we see the top of that range again. I plan on shorting them.

Dow Chart - Daily

Nasdaq Chart - Daily

Until the June Fed meeting I believe the market bias will remain negative even if we see some material attempts at a rebound. The summer doldrums are approaching and the bulls have taken a serious pounding. This has depleted their account size and left a bad taste in their mouth. They will not be rushing back into the momentum stocks until their wounds heal. I have taken about 20 stocks off my trading list and pared it down to only five plus the Russell, gold and crude oil futures. That is more than enough to keep me busy until a new market trend develops. I believe that process is being repeated by millions of other traders this week and that takes a lot of juice out of the market. I am sure everyone has seen choppy summer markets bleed funds out of their accounts. I have a lot of expensive experience in trying to trade the chop and I have learned to step aside when it appears. I believe we have another few weeks of decent trading ahead of us but then we need to go into vacation mode if the market starts trending sideways. I will continue to watch it for you and keep you updated with my outlook. It is your choice to act on it. Did you short SPX 1315? Do you wish you had?

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