Sellers left early for the long holiday weekend and they returned with a vengeance on Tuesday. After a weak performance by overseas markets and some negative economic news the U.S. markets gapped lower at the open and never looked back. I discussed a scenario in the Sunday newsletter suggesting sellers had simply paused to let the markets breathe on Thr/Fri and avoid trying to unload large positions in very thin holiday trading. I suggested the selling could return this week along with the volume. I had expected Wednesday to potentially worse than Tuesday due to lingering light volume on Tuesday and the worry about the FOMC minutes on Wednesday. The economic news this morning and Fedspeak from Moskow may have soured those plans to wait for volume to return before the resumption of selling.
Dow Chart - Daily
Nasdaq Chart - 30 min
Russell-2000 Chart - 30 min
The morning started off with a warning from Wal-Mart that same store sales for May rose only +2.3% and at the low end of the prior +2% to +4% projections. Wal-Mart said higher gasoline prices and utility bills were continuing to pressure customers. This pressure was showing up strongly in the paycheck cycles. Sales were grouped more closely around paydays with lower sales levels being seen between paydays. Consumers are clearly feeling the pain at the pump and sales at Wal-Mart is the leading indicator of that pain in the blue-collar community. WMT fell -3% on the news with other retailers also feeling the pressure. There is real concern that this consumer malaise will translate to all retailers. However, some analysts feel the problem will be more pronounced at Wal-Mart due to their broader low-income customer base while higher ticket retailers will be impacted less.
Also impacting the outlook for consumer health was a drop in Consumer Confidence from 109.8 to 103.2 for May. The expectations component declined from 92.3 to 83.7 leading the headline number lower but the present conditions component also fell to 103.2 from 109.8. Consumer sentiment on the availability of jobs also fell with the outlook for business conditions sliding. The decline in the headline number from April's nearly four-year high was blamed on gasoline prices and rising interest rates. Those consumers planning to buy homes shrank as well as those expecting to go shopping for new cars.
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Energy prices continued higher on Tuesday after reportedly strong holiday demand for gasoline. Oil rose to $72.75 intraday and a nearly two-month high. Energy stocks did not benefit as the market implosion weighed on them despite the spike in oil prices. The recent geopolitical themes were blamed for the oil spike. There is a new package of incentives and potential sanctions that will be reviewed on Thursday by the five permanent members of the UN Security Council plus Germany. Basically the peaceful process is finally winding to an end and Iran's window of opportunity is closing. It has taken two months of meetings to come to an agreement within the committee and for Russia and China to finally lose patience with their rowdy Iranian neighbor. After two months of refusals to halt its nuclear program for any reason and threatening the individual council members, Iran turned suddenly conciliatory ahead of Thursday's UN meeting. Using the Saddam Hussein rope-a-dope tactics of promise, stall and evade to buy time over the last two months Iran suddenly announced on Tuesday it was willing to resume negotiations with the EU three, France, Britain and Germany, "without any preconditions." They did rule out direct talks with the US. I am sure Iran believes it can get greater concessions from the EU three since they are working from a weaker position. We should see further movement on the problem by weeks end, which means it will be in the news all week. The UN group is close to recommending what sanctions should be implemented if Iran continues its refusal to stop the program. Among the possible sanctions are a visa ban on government officials, the freezing of assets, blocking financial transactions by government figures and those involved in the country's nuclear program, an arms embargo and a blockade on the shipping of refined oil products to Iran.
OPEC meets in Venezuela on Thursday but despite pleas from Hugo Chavez they are not expected to change the current production rates. In a side note two OPEC members have announced they will not be making the trip to Venezuela. I think this is an interesting development after I joked a couple weeks ago that members might fear for their safety inside the Chavez controlled country. Maybe there was more truth to that fear than I thought.
Also impacting the price of oil was a report that China's oil demand rose +10.8% in April and the highest jump since 2004. Auto sales in China jumped by nearly +50% in the first four months of 2006 creating a +20% rise in demand for fuel. China has a price cap for fuel so civilians are insulated somewhat from the current high prices. That does not help the rest of us who have to pay the current high prices based on their increase in demand.
Crude Oil Chart - Daily
The FOMC minutes are poised to take center stage on Wednesday but the supporting cast of reports includes the NAPM and PMI. The FOMC minutes will be key given the current worries about the Fed views on inflation. Part of the market slide today was attributed to comments by Chicago Fed President Michael Moskow on CNBC before the open. Moskow is known to be hawkish on inflation but his comments suggested an even firmer stance than previously thought. Moskow said inflation at 2.1% was currently at the high side of the Fed's comfort range. This is nothing new since we have written about it seemingly daily for a month. However, Moskow went on to say the Fed should not be content with holding the line at +2.0% but should push it back to the middle of the comfort zone. He said allowing it to hold at the top of the range created risk of a sudden inflationary spiral that experience has shown can be hard and painful. In chart terms he fears a sudden breakout over resistance at 2.0% leaving the Fed in a race to catch up rather than maintain preemptive control. Moskow said the Fed should not have a "zone of indifference" and he would rather see an inflation target in the middle of the acceptable range rather than hovering at the extreme top or bottom for an extended period of time. Why tempt fate with inflation poised at the breakout point? Fortunately Moskow is not a voting member of the FOMC for 2006 but his feelings are still a pressure for the committee. The comments in the very public CNBC interview slammed the markets with fears that the Fed could continue raising rates and when coupled with several other comments of late those hikes could be stronger than 25 points. He also said that Fed credibility was crucial to fighting inflation and to the markets confidence in the Fed. With the Bernanke blunder last month many feel the Fed head has lost that credibility edge and will have to hike rates again and maybe shock the market with a 50 point hike to regain credibility. We are in the new phase of "data dependence" but how the Fed reads the data could be different than how the market reads it. On Saturday SF Fed President Janet Yellen warned that the current weak dollar could, in theory, force a tighter Fed policy by stimulating aggregate demand and raising inflation risks. The market is reacting to multiple cautionary comments from multiple Fed speakers over the last week and this makes the FOMC minutes at 2:PM on Wednesday very critical for the official Fed viewpoint. Expect extreme volatility when they are released.
Following the FOMC minutes the markets will focus on the ISM on Thursday and the Nonfarm Jobs Report on Friday. Consensus on the ISM is for a drop from 57.3 to 56.0 for May. Consensus on the jobs report is for a gain of +173,000 jobs. If the ISM shows a sharper than expected drop it could soften the fears of a potentially more aggressive Fed. It is highly unlikely that the jobs report will show greater than expected gains and highly likely that any job gains will disappoint. That would also be Fed friendly. Remember, the Fed has said they are expecting the economy to slow as the recent +400 basis points of Fed tightening filters through the system. It takes a minimum of six months and potentially 12-18 months for the last hikes in a cycle to be felt completely. The Fed has raised rates +16 times starting in June-2004. Easily half of those hikes have yet to be completely integrated into the economy. This snowball of forward rate impact is on a collision course with the slowing second half economy. It is imperative the Fed not go too far with its hikes but also imperative that inflation not increase past the current +2.1% level. This is between the proverbial rock and hard place that the Fed always seems to find itself. That makes the economic reports for the week even more critical given the recent flurry of contradictory Fedspeak.
The White House named Goldman Sachs CEO Henry Paulson as the new Treasury Secretary to replace John Snow. Snow had been expected to depart for sometime and it appears the move to enlist Paulson has taken nearly a month. The choice was widely applauded by both Republicans and Democrats and he should have no trouble getting past the approval process.
Dow -184, Nasdaq -45, S&P -20. Welcome to Dancing with the Bears, round two. As I researched the carnage it appears to be a continuation of the selling that we saw early last week. I say that because the same commodity stocks that bore the brunt of last weeks selling were slammed again today. Emerging markets were weak again and the sickness appears to be contagious. Like I said on Sunday I felt there was a good chance the sellers had simply stepped aside on Thr/Fri to avoid the thin volume trading and give the markets a chance to breathe. If that was the case those same sellers came back strong and knocked the breath back out of the markets with a serious sucker punch. I spent a very long time trying to find some correlation between the indexes with careful review of every index factor I could find. Unfortunately I could not find any real clues for tomorrow other than the obscene imbalance in the internals. If we apply normal rules to today's sell off then there could be more to come.
The advance/decline volume completely reversed from the trend we saw as last week ended with declining volume beating advancing volume by nearly 6:1. This was a dramatically stronger imbalance than the light volume gains we saw on Thr/Fri. The only saving grace was the overall light volume at only 4.3B across all markets compared to last Wednesday's 6.5B on what was seen as a capitulation day to the sell off. Actually, Tuesday's volume would have been a lot less had a very large sell program not triggered at 2:30. Volume increased by nearly 50% in the last hour of trading alone and was still accelerating into the close. It appeared the decline caught the big funds off guard and once the lows for the day were broken just after 3:PM everybody pulled the sell trigger.
Table of Market Internals
If this was a simple program trade event there should have been some rebound in futures after the close. That has not happened yet. With overseas markets still weak there it would appear overnight traders are waiting to see if Asian markets follow our implosion lead as they often do.
I also mentioned on Sunday that there was a substantial group of traders expecting a retest of the lows this week and they were waiting on the sidelines for that test. It remains to be seen if they made the right decision but I am sure they are already squirming with anticipation and money burning a hole in their trading accounts. A successful retest would mean a continued dip of -60 additional points on the Dow, -25 on the Nasdaq and -15 on the S&P. Since the indexes rarely trade in lock step those numbers could vary slightly by index but you get the picture.
I am actually a little more fearful that a retest may end in disaster. This is not just a garden variety sell off we have been witnessing. It is global in reach and almost no sectors have been immune. It has been weighted heavily towards energy and commodities but also included sharp drops in all the emerging markets. That coordinated emerging market drop has never been seen before to this extent and that smells like a broader problem. There are rumors of hedge funds in trouble but that rumor pops up whenever there is a market event. It appears more likely to be sector rotation by major funds out of the ETF momentum plays that have worked so well over the last couple years. With predictions of slowing growth both in America and overseas and fears of another unexpected cycle of rate hikes it may be a rotation of funds back into the U.S. and onto safer soil. The flaw in this scenario is the weeklong fire sale in bonds. Bonds are supposed to be safe havens in times of trouble but nobody is buying even with yields over 5%. Something is fishy and even Sherlock Holmes would have trouble finding the specific reasons for our weak markets.
The sell in May and go away crowd were getting their 10min of fame on CNBC today with Jeffery Hirsch from the Stock Traders Almanac reciting the historical numbers. Since 1950 $10,000 invested in the market from Nov-1st through April-30th would have grown to a little over $500,000. A similar sum invested from May-1st through Oct-31st would have produced a -$300 loss. That should be enough evidence to keep everyone out of the markets over the summer but most of us are stupid. We believe we can beat the averages due to our skill in choosing summer investments. Still, the best six months strategy as described by Jeff has quite a few followers. While I doubt that is the reason for the sell off I am sure those who did exit three weeks ago are very glad they did. Jeff also reminded everyone of the election cycle problem. The 2nd year in an election cycle is typically a tough year for the markets while the next two years are typically bullish. That year for a second term president is even harsher. Jeff was expecting a return to Dow 8500 followed by a rally in 2007. He probably lost a lot of credibility with that prediction and few will remember his claim if it does come to pass.
Trying to balance all the factors and predict the markets for the rest of the week is even tougher than normal tonight. I do believe we are setup for a potential retest of last week's lows but it is also entirely possible today's flush was the last gasp of selling for May. Month end for May is Wednesday and while May is not a big month for retirement contributions the incoming cash flow is still positive. Last week I suggested the drop would end with a rebound with two potential targets, 1275 and 1295. More importantly I expected the markets to remain range bound between 1250-1295 for several weeks. We saw a rebound appear that took us just past the first target at 1275 to close at 1280. The instructions for today were to short a drop back below that 1275 level. My recommendations for Wednesday would be to buy a bounce from the bottom of the range at 1250 or so as a trading buy. We are moving rapidly into the summer doldrums but this current volatility still has room to run before the charts flat line for summer.
SPX Chart - Daily
The FOMC minutes at 2:PM should produce a volatility spark. We could move triple digits in either direction once those are released. Obviously a substantial opening drop would blunt any downside FOMC pressure but anything is possible.
I would be careful tomorrow. If you are not a trader this is probably not a day you want to be in the market. The VIX jumped a whopping +4.40 points to 18.55 on Tuesday and the Nasdaq VXN spiked +3.52 to 21.84. Most of that spike was related to the extremely negative internals produced by the late day sell program but for whatever reason it is still extreme. Option premiums should be very inflated and even if you pick the right option/stock the eventual premium bleed once volatility eases could make it difficult to profit.
Too keep my analysis and recommendations simple tonight I will try to net it out for you. I believe the afternoon plunge was due to a major sell program and there is no way to tell if it is over since the selling continued right into the close. The overseas markets should follow our lead and open down. No surprise there but it is how they close that will impact our open tomorrow. The Chicago PMI is released at 10:AM and the FOMC minutes at 2:PM. Be prepared for volatility surrounding each. Look to buy a bounce from the SPX 1250-1255 level but otherwise remain flat unless you are already short from 1275 per my Sunday recommendation. Should 1250 break I would remain short with an initial 1225 target. Trying to enter new positions in Wednesday's expected volatility at other than the bottom of the recent range (1250-1255) could be dangerous. There is always another day and another trade. My very short-term bias is down until we complete the retest or some external event changes the dynamics of the current market.