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Market Wrap

200 Day Retest

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If close only counts in horseshoes and hand grenades then today's market dip may not count as a valid retest of the May lows. However, multiple indexes including the S&P 100 and 500, Russell 1000 and 2000 and the Wilshire 5000 all retested their 200-day averages. Unfortunately the rebound from those averages was less than stellar. Analysts are suddenly turning more bearish by the day and talk of new market highs has evaporated. It appears to me that conditions are forming for a major market move but the direction is still in question.

Dow Chart - Daily

SPX Chart - Daily

Nasdaq Chart - Daily

As I sat down to write this commentary I was really challenged about what to write. While everyone knows I am never at a loss for words the problem was a complete lack of directional indications. My bias in the weekend commentary was as close to neutral as I have been in recent weeks. With the S&P sitting at 1290 resistance my recommendation was to short any failure at that 1290 level but also be ready to go long if we broke 1300. As you know I have been bearish for several weeks but a break over 1300 would have pulled me back from the dark side. Instead the weakness at Monday's open confirmed my suspicions and we got a very nice short side ride back to support at 1255. Since mid May my recommendation has been to buy a rebound from the 1255 level and that worked well again today, BUT that scenario may be changing.

The return to the May lows was not surprising. I suggested several times over the last four weeks that we were likely to trade in a range between 1250-1295 until the FOMC meeting at the end of June. So far we have done exactly what was expected. What is changing my outlook is the rapidly changing Fed outlook. It seems we are vacillating 50% points in the Fed funds futures outlook on nearly a daily basis. Last week the odds of a hike in June were hovering near 80%. After the Friday Jobs data that fell to near 40%. After Bernanke's scorched earth speech on Monday we are back to 80% all over the course of three days. This shock to the markets is more than many can bear. Institutional traders and hedge funds plan positions worth billions of dollars on how they expect the Fed to act. When that outcome is changing drastically on a daily basis they can't make those plans. The uncertainty keeps them from taking positions and causes them to reduce the size of those positions exposed to Fed risk.


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On Monday Bernanke spoke like an inflation hawk and warned that the Fed would remain vigilant and aggressive on inflation. He even went so far as to suggest the Fed was ready to burn down the economic village to protect it. He did not use those words but that was the meaning. He said economic growth would be sacrificed to prevent inflation growth. That is nothing new for the Fed since they always slow growth through rate hikes to keep the economy on track. It was the tone Bernanke used suggesting he was almost willing to put the economy into recession in order to drive a stake through the heart of the inflation monster.

Bernanke was supposed to be the opposite of Greenspan with easy to understand Fedspeak and clear guidelines. What he has become as the new Fed head is a male model of the 1960's Chatty Cathy doll spewing random Fedspeak whenever somebody pulls his string. Unfortunately his comments have all the directional consistency of a flag in tornado. Because Bernanke has made some communication mistakes early in his term his credibility has been questioned. Now to regain his credibility and prove his manhood in front of his peers he may be forced to raise rates longer or sharper than the market currently expects. His comments on Monday left almost no doubt that they will hike in June regardless of the data and that created confusion in the markets. Are the rate hikes data dependent as the Fedspeak previously claimed OR are they credibility dependent? Enquiring minds want to know.

As if to provide support for Bernanke's scorched earth speech on Monday the other Fed speakers were out in force on Tuesday. St. Louis President William Poole said, "If inflation turns out to exceed our expectations, our target range, I do not believe we can count on a slowing economy to bring inflation down, by itself, quickly." Also, "We need to have an upside bias to our setting of the Fed funds rate. I think it would be a lot safer strategy to err on the side of going too far, in the expectation that when that became clear, you could back off." We all know how successful that strategy has been in creating recessions in the past. Federal Reserve Governor Susan Bies said, "The Fed does not know the exact interest rate setting required to balance high readings on inflation with expectations of slow growth." Also, "We are in a period where we are in transition and transition means we don't know exactly where we are going to stop." If the Fed doesn't know then how should the markets know? Kansas City Fed President Tom Hoenig said, U.S. economic growth will moderate as the year progresses and inflation will also "taper off." "It is too early to tell if the Fed is behind the curve on inflation." He said, "The Fed had just reached a neutral rate that neither boosts or retards growth." That suggests additional hikes are necessary to combat inflation if slowing growth is not going to stop it. All speakers today spoke of the lag between rates and economic impact and all voiced concern that we were only beginning to see the impact of the current rate hike cycle. Considering the Fed has raised rates 16 times and according to the Fed heads themselves we are just beginning to see the impact this should suggest the need for severe restraint to avoid increasing that impact just when the economy is starting to tank.

All of these Fed speakers just added to the concern that Bernanke could be on a path to economic destruction as he tries to regain credibility by raising rates. The confusion sent buyers back into bonds rather than stocks and the resulting drop in yields produced an inverted yield curve between the ten-year and two-year for the first time since March 29th. While TV commentators would have you believe it was all about the Fed there are more far reaching concerns. We have seen rate hikes in Japan, China, Canada, UK and probably by the ECB before the week is out. It is not just a US problem but a global attack on growth. Still, it is not just rates pressuring the US markets. We have seen a severe rotation phase out of nearly every global market not just the US. For instance Brazil is down -24.5%, Mexico -18.4%, Japan -12.5% and -8.3% for the UK. I could go on but you get the picture. After a major sell off in emerging markets and commodities in May we saw a rebound from the severely oversold conditions but that rebound was only temporary. Metals were killed again today with gold -$7, silver -3.7% (-.46) and copper -3%.

Crude was down -$1 intraday and rebounded to flat just before the close. Crude slid on comments from Iran that the UN proposal had some "positive steps" although there were some ambiguities. Bush said Iran's initial response "sounds like a positive step." Iran must have received some heated calls from Russia and China on Monday after threatening oil supplies flowing through the Strait of Hormuz. If you are trying to avoid UN pressure you should not agitate the world with threats of violence and a halt to Middle East oil exports. I told you the "we won't play the oil card" comments Iran made dozens of times over the last couple months was really an implied threat. On Monday the veil came off that implied threat to the dismay of everyone. We have to assume that Russian and China were quick to make a "what were you thinking" call to bring them back into line. Of course that is a very thin line that borders on the edge of reality. It will be interesting to see what comes out of Iran over the next couple of weeks. The unofficial deadline for a response is July 15th but I suspect we will see some fireworks well before then.

Helping oil rebound late in the day was news from the EIA that they raised their estimates for demand growth for 2006 and 2007. The Energy Information Agency said high prices may not slow demand growth as previously expected. As consumers become accustomed to higher prices demand is returning. (Anybody who thought different was delusional.) The EIA raised its 2006 growth forecast by +100,000 bpd to +1.7 mbpd. They also raised its 2007 demand growth forecast to +1.9 mbpd. To put that in simple terms it means an additional 3.6 million bbls per day will be added to global demand between 12/31/05 and 12/31/07. That is more than new production scheduled to come online over the same period and that does not take into account the -4% decline per year (-3.4 mbpd) in current fields. Doing the math you get the following result:

Oil Production Table

Those are just estimates because there is very little credible data on new production coming online and declines in existing fields can be partially offset by technology improvements. A new field predicted to produce 50,000 bbls per day may only produce 25,000 by the date initially predicted due to production delays and changes in real output compared to optimistic estimates. New production can be delayed sometimes for years due to weather, equipment shortages, incomplete pipelines, etc. Basically it is not production until it flows down the pipe and that is when we can count it. According to the most optimistic estimates nearly 7 mbpd of new production is expected to come online through 2010. Unfortunately if you continue the math in the table above through 2010 it gets really ugly even if all 7 mbpd actually appeared in the pipeline.

The EIA also warned that 35 million bbls of 2006 production could be lost if the warnings of a strong hurricane season come to pass. 15% of gulf production is still offline from the 2005 season. Oil prices also found support by revelations that Saudi production had dropped to 9.1 mbpd compared to their stated capacity of 11.3 mbpd. The Saudi oil minister speaking at the OPEC meeting in Venezuela said the drop in output was due to a drop in demand rather than an effort to hike prices. This is a drastic change in Saudi policy. Saudi has long been the price control country in OPEC. When prices needed to be pushed lower Saudi would maintain production at a point where prices would decline from oversupply. This is how they kept high prices from killing demand, stimulating alternative fuels and an exploration boom. If that price control component has now changed to a reduction of excess production then higher prices are definitely here to stay. I should also remind everyone that current excess Saudi production is heavy sour crude and is not in high demand due to limited refining capacity. It is not the light sweet crude currently going for $72.50 tonight. The bottom line will be continued high prices for oil but not necessarily in a straight line. $100 oil is guaranteed and only a matter of time.

July Crude Oil Chart - 60 min

The market dip today came very close to a retest of the May lows. Close enough for me since retests have a habit of coming up short as dip buyers jump in early in anticipation of a bounce. Starting with the S&P we saw a dip to 1254 compared to the 1245 we saw on May 24th. With the 200-day average at 1260 this area becomes decent support and a range that should hold if we are just experiencing a retest before moving higher. Unfortunately the markets are so nervous that it is hard to tell if the dip is a retest or an opening act for the next big drop.

DDow Transports Chart - Daily

The Dow and the Dow Transports are the only indexes that fell below their May lows. The transports broke their low by about -12 points and the Dow by -104 points. The Transports rebounded +85 points from the intraday low at 4523 and a successful 100-day average test at 4541. This was the most bullish rebound of all the indexes. The Dow slid below 11000 intraday to 10926 and -120 but recovered the 11000 level at the close to narrow its loss to -46 points. The 10926 intraday low was the support low dating back to the March 8th dip. There were actually two rebounds intraday. The first ended at 12:45 at 11008 and the Dow quickly retraced its dip back to 10960 before that closing spike back to 11000.

Neither rebound produced any confirmation for traders. They were slow and on light volume. Down volume was only 2:1 over up volume and far less of an imbalance than needed for rebound confirmation.

Market Internals Table

Without any material sign of buyers returning to the market in volume it suggests this dip has further to go. It could also just be a symptom of the nervous market given the global weakness and the Fed confusion. Either way the dip reconfirmed my long-term bias to the downside. Even if another rebound appears, futures are positive as I type this, I seriously doubt it will have any legs and be able to reach the 1290-1295 resistance range again. Traders will have far less confidence on this bounce than the last. Unless funds show up with massive buying volume we are probably looking at another failed rally ahead.

Stock news is practically nonexistent and what news we do get has been predominantly bad. It is still too early for the earnings warning cycle although several have appeared. We are seeing more analyst downgrades for various reasons and in this market the damage has been instant. CELL would be the example of the day with a downgrade from Deutsche Bank to hold from buy. CELL lost -18% to close at $16.25. When bad news happens in weak markets the impact is normally dramatic. I believe we will continue to see this type of damage as the month progresses. Once the warning cycle arrives in full force it could be ugly since the markets are already dysfunctional with three weeks to go before the Fed meeting. This is also expiration gyration week. It is the week before expiration and the week where institutions typically adjust positions. It is not a quarterly expiration so the impact should be negligible but it still exists.

For the rest of the week I would be careful with any long positions. If we do get a rebound I would expect resistance at 1275 to be the first decision point followed by 1290. I would continue to short any failed rally and this time I would NOT buy a dip to the 1250-1255 range on the S&P. I had expected the 1250-1295 range to hold through the FOMC meeting on June-28th but the recent Fedspeak has soured my outlook for that scenario. I believe any dips to the 1250 range will have progressively smaller rebounds with 1250 eventually breaking. If 1250 does break I could see 1225 as next support but that may only be a bump in the road. SPX 1190 would be a -10% drop with 1175 entirely possible. IF, and I say IF in capital letters, 1250 breaks it would probably be accompanied by a break in the 200-day average by the Wilshire-5000 and Russell-2000. This would be a classic technical sell signal for funds and we could get a real washout. This is a typically volatile period in the markets and it could get worse. For reference there were 125 days with more than a 1% move in the S&P in 2002 and that was post bubble and post 9/11. Using that as a baseline reference it compares to only 30 days in 2005. Traders used to the relatively calm markets in 2005 could be in for a really exciting ride in 2006. Fasten those seatbelts!

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