Option Investor
Market Wrap

Weak Week

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It was the weakest week for the Dow since June 2005 with a -356 point drop and the worst for the S&P since April 2005. The Nasdaq closed at a seven month low after six straight days of losses. Thursday's rebound failed to create any follow through and the markets closed at their lows on Friday. It was a fitting end to a very bearish week.

Dow Chart - Daily

Nasdaq Chart - Weekly

Dow Transport Chart - Daily

Friday's economic reports had little to do with the continued weakness but they did get their share of airtime. Import prices rose +1.6% in May and twice the consensus estimates. 1.0% of that increase was due to a +5% rise in oil prices. The May increase of +1.6% and the April jump of +2.1% was the largest two month jump since October 1990. Export prices rose +0.7%. The trade deficit for April was -$63.426 billion, an increase of +$1.5 billion over March. The deficit with China increased to $17.0 billion. The major problem is the weakness in the Chinese yuan. It is thought to be about 40% undervalued when compared to the dollar. That makes their exports cheaper and imports into China more expensive.

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After a decline from 28% in June-2005 to 15.7% in April-2006 the Risk of Recession as calculated by Moodys rose to 20% in May. This is the projected chance of recession over the next six months. Since most analysts are targeting early 2007 for a recession possibility it is still a little early for this index. Factors contributing to the jump are factors that could push it significantly higher over the next several months. Consumer confidence, weak equities, rising interest rates, the treasury yield curve, unemployment claims and the falling housing market. Iowa, New Hampshire and Mississippi are all showing risks over 30% with California and Illinois having the lowest risk.

The Blue Chip Economic Indicators survey of 50 leading economists was released on Friday and the outlook has declined across the board. The GDP for Q1 is currently showing to be 5.3% but recent economic reports this week suggest it could be revised upward to 5.9% or even as high as 6.2%. If it is revised higher it will make the plunge to the levels expected for the rest of 2006 seem even sharper. 2007 is already starting off low and with a growing number of analysts expecting the Fed to go too far the fear of a recession in early 2007 is growing.

TTable of GDP Estimates

The BCEI estimates for inflation predict a rise to 3.3% from their earlier estimate of 3.1%. With current inflation at 2.1% after the May reports it suggests we are in for several more Fed rate hikes. 3.3% inflation is well off the Fed comfort scale. However, the survey did expect the slowing economy and continued Fed action to push inflation back down to 2.5% in 2007.

Corporate profits were expected to finish the year at an upwardly revised 15.5% rate. We have seen previously lowered estimates for the last two quarters revised upward as earnings refuse to die as expected. However, stronger comparisons and a slowing economy are expected to produce a bear market in earnings growth for 2007 with a drop to ONLY +3.9% for the entire year. With the current S&P price to earnings ratio at 17.75 it suggests limited upside for the markets and probably a period of PE compression. That means stock prices will be pushed lower to compensate for lower earnings growth. This is a temporary cycle since an expected economic rebound in the second half of 2007 will allow prices to move higher. Markets typically anticipate this increase in earnings by 6-9 months. Bear in mind that these BCEI estimates are just that, estimates. We have seen how the economy and specifically earnings growth has surprised analysts for the last two quarters.

Table of CPI/EPS Estimates

Next weeks heavy economic calendar has several potential stumbling blocks. The PPI and CPI will give us the current reading on inflation while the Fed Beige book for May will show us all the data the Fed will be using when they meet later in the month to raise rates. In addition there are two Fed surveys, which are expected to show slowing growth. In the table below I highlighted the most market reactive events.

Economic Calendar

There are so many things to cover about the last two days I hardly know where to start. The Dow traded in a 500-point range for the week and that would normally produce a turning point but the bullish outlook is still dim. Internals on Friday were decidedly negative at 2:1 in favor of decliners and declining volume indicating the selling is far from over. The carnage has been widespread and while commodities and metals were hardest hit early in the process the selling has broadened to cover nearly every sector and stock. Of the Dow 30 only 1 stock, JNJ, has posted a gain since the FOMC meeting in May.

Table of Dow Stocks Since FOMC

Losses in Metals Since FOMC

As I have stated before the carnage within the United States markets has been relatively limited compared to the damage in other global markets and the ETFs associated with those markets. The problem is the unwinding of the carry trade. As a refresher, the carry trade is where large hedge funds and institutions borrow cheap money abroad such as the nearly zero percent loans available in Japan. They use this money to speculate in equities and commodities around the globe. The global markets, especially the emerging markets have been rising so quickly that made them a perfect place to put this money to work. Since January 1st many of these markets have risen +50% or more! That would be the equivalent of the Dow rising to 21,000 or the Nasdaq 4200 just since January 1st. Massive profits have been accumulated by these investors. Since we all understand leverage it should be no shock that these funds were so excited about the money mill they borrowed heavily to add to their successful investments. Eventually this house of cards, like our Nasdaq in 2000, would fall. According to TrimTabs individual investors moved over $500 billion into ETFs and mutual funds invested overseas between October 2004 and April 2006. Many of these markets were seeing cash inflows equal to or greater than their existing capitalization. If you have a market worth $20 billion and suddenly Americans want to buy $10 billion worth of that market it creates a spike that makes our two-year tech bubble in 2000 look tame by comparison. We all know profits are not profits until they are safely back into cash. Once the fire drill began it was a race to the exits. Like the spike higher after January 1st the extraction of 25% to 35% of your entire market capitalization is going to cause some volatility. Since many hedge funds and most individual investors use the ETF/iShares for their investment the panic exits caused these exchange traded funds to fall farther than the index they represented. In the table below I listed a few showing the drop in the corresponding market for that country and the drop for the ETF. Note that the ETF drops are substantially higher except in the case for Argentina's ILF, which covers four countries not just Argentina.

Table of Country/ETF Declines

Indonesia Fund Chart - Daily

Helping to erase this carry trade impact is the sudden burst of rising interest rates around the globe. Free or nearly free money has been rampant for so long that literally hundreds of billions could be at risk. Last week seven countries raised interest rates and more are expected. Countries raising rates included India, Turkey, South Africa, Thailand, Denmark, South Korea and the ECB. Japan has been extracting massive amounts of liquidity in preparation for a series of rate hikes after years of nearly zero interest. When interest rates rise it is the equivalent to the keg at a frat party going dry. The party ends quickly.

There is some good news to this story. Once the carnage is over analysts do not expect this money to return to the international funds. Everyone knew the gains were too good to pass up as the markets rose but now everyone is going to be skeptical until the markets have a chance to find their own level again. Nobody wants to put their money back into the fund only to have another round of selling on the next bounce. That cash is likely to find its way back into the US markets once they feel the current dive is over.

On Friday TrimTabs also said corporate cash was at record levels and buybacks were also at record highs. Just since May 1st 162 companies have announced over $70 billion in new or expanded buybacks of their own stock. Coupled with earlier buybacks by others already in progress TrimTabs estimated over $1.5 billion was being repurchased every day based on the announced date ranges and amounts. The last time buybacks were this strong was between June-2002 and Feb-2003. During that period individuals withdrew $102 billion from mutual funds while corporations completed over $30 billion in buybacks. Some recent additions to the announced buyback list include AXP $10.5B, PEP $8.5B, UNH $7.0B, CSCO $5.0B and NWS $3.0B and it is a long list. TrimTabs also said individuals had withdrawn over $6 billion from funds since May 9th. I personally thought it would have been higher. Charles Biderman said market gains after these buyback cycles typically ran between +9% to +15%. At least we have something to hope for!

Global markets are not the only markets still feeling the pain. Commodities, metals and stocks with strong gains are still reeling under the selling. Oil was up +$1.28 on Friday to close at $71.64 and oil stocks were still getting crushed. Like the global ETF gains some story stocks had seen extreme gains within the US. Until these gains are turned into profits the selling will not be over. Some of the major winners for the year are listed in the table below. When you realize the gains over the last five months the profit taking is not that bad. For instance PEIX went from $10 to $45 and even with a -45% drop it is still trading at $25 and a +150% gain for the year. That is unless you were the last to buy at $45.

Table of Large Winners/Losers

Adding to our problems last week was an extremely large option rotation. Traders told Rick Santelli in Chicago that there were an unusually large number of option positions being closed on Thursday. I mentioned this as a risk last Sunday but I thought it would be minimal for a non-quarterly cycle. The high volume could have been related to the major market move since May-10th requiring an unusually large number of position adjustments. Rick also reported heavy put buying on Friday.

From my viewpoint there just doesn't seem to be any buying interest even on good news. For instance the SOX dropped on Friday despite good news from National Semi and Texas Instruments on Thursday night. There was also an upgrade to the chip outlook from the Semiconductor Organization and it also failed to help. The SOX closed the week with more than a -6% loss.

I added a column showing percentage change for the week to the market recap graphic at the beginning of this commentary. You will note that the NYSE Composite, Russell-2000 and Dow transports lost over -4% for the week. These were the indexes, which were the most bullish in the weeks leading up to the FOMC meeting in May. Like the global market implosion they are feeling the pain as profits are extracted. I updated the index graphic below to show the lows for the week and highlighted those already past the -10% level. Those few indexes remaining, which have not reached the ten percent mark are quickly approaching those levels. When I created the table three weeks ago I thought Dow 10500 was a long way off. At after testing 10750 it does not seem that far away.

Table of Index Correction Levels

In a special update for the LEAPS Trader newsletter on Thursday night I told readers I did not feel the rebound would hold. Despite the massive volume on Thursday of 7.527 billion shares and a +200 point rebound for the Dow, +44 for the Nasdaq, there was selling all the way up. There was never any scramble to buy stocks and despite the large point rebound the internals barely made it back into a 1:2 ratio on the advancing/declining volume. This was depressing since the ratio was 15:1 declining over advancing volume early in the day. It was a textbook capitulation day from the early day internals but it turned out to be just a chapter in the book not the conclusion.

Market Internals for Thursday Rebound

Unfortunately I still feel that way this weekend. I simply don't see any real buying interest. Dip buyers were hammered on every minor rebound on Friday and the pattern of late day selling is returning. I know we can't pin a lot of market outlook on Friday's close since there was any number of reasons why traders hit that sell button before the bell. What we can count on for next week is another round of inflation news and nearly every Fed head is going to be on a podium somewhere. This will be the last week of Fedspeak before their pre meeting quite period. We also have the retail expiration exodus as June options expire.

The indexes are starting to reach some strong support levels and it will take a lot more effort for the bears to push them lower. It will not be impossible but the easy money for shorts has been made. The Dow hit 10750 on Thursday and 10700-10750 is very strong support. This is where I would circle the wagons and make a stand as a dip buyer.

Dow chart - daily

Likewise the 2100 level on the Nasdaq was reached on Thursday and it should be a sizeable speed bump to slow down the bears. The rebound from 2100 was relatively quick compared to the other indexes. I actually thought for a while we had a real rally in progress based on the Nasdaq bounce. A second test of 2100 would be an effort but could be seen as a confirmation test.

Nasdaq chart - daily

I was particularly impressed with the S&P and the speed it reached falling from Monday's high of 1287 to Thursday's low of 1235, -52 points. With 1240 decent support I believe the 1235 penetration was simply a momentum overshot and I was relieved to see the quick rebound over 1240. If that level breaks on a retest we could see 1200 or even 1185 very quickly.

SPX chart - daily

All the indexes except for the Dow, NYSE Composite and the Transports have broken their 200-day average. This is a technical sell signal for many funds. If we see additional weakness on Monday I believe it could gain speed rather quickly to those critical support levels I mentioned above of 10750, 2100, 1240. If those break it would be a confirmation sell signal in addition to the 200-day failure. In layman's words grab your parachute and bail out quick.

Offsetting the technical mumbo jumbo is the extreme oversold conditions and sentiment factors. With the Nasdaq down six days straight and the Dow 5 for 6 and minus nearly 800 points this rubber band is stretched nearly to the limit. With two weeks to go before the Fed meeting and a 90% certainty of another hike the bad news is already priced into the market. While worsening inflation data in the PPI/CPI (Tue/Wed) could cause another wave of selling pressure most analysts and traders already expect it. If we should receive a lower inflation surprise in those reports it could prompt a rally on hope the Fed may not have to pull the trigger again. While I think that is highly unlikely it is a possibility. Fed Director of Monetary Affairs, Vincent Reinhart, said on Friday the Fed must draw a firm line in the fight against inflation. As the top Fed staffer on monetary issues, Reinhart presents the FOMC with policy options during the regular FOMC meetings.

There will probably be no shortage of geopolitical events to keep the markets off balance next week. After the bell on Friday the State Dept warned Americans in China of a potential terror threat. The US Embassy in Beijing said it had received information of a possible terrorist threat against American interests in China, especially in Beijing, Shanghai and Guangzhou. They warned citizens to avoid places where Americans congregate, including clubs, restaurants and schools. Nigeria said that oil production offline due to sabotage was worse than previously reported. Nigeria said over 800,000 bpd of light crude was offline rather than the previously reported 500,000. The weather service reported heavy thunderstorm activity in the Caribbean in what could be the early stages of a tropical storm. Should one actually form and head for the gulf we can expect oil prices to rocket higher. Gasoline demand for last week fell slightly as higher prices took their toll on the actual holiday driving. This slight decline helped depress oil prices only for a day before the Thr/Fri rebound. Average gasoline demand is only 81,000 bpd behind last years average but three of the highest usage weeks are still ahead. Gasoline is 70.2 cents higher this summer than last.

Table of Gasoline Demand

Crude Oil Chart - 120 min

So far our May/June game plans have been working well. The Tuesday night recommendation was to expect the Tuesday bounce to fail and to short that failure at 1275. I also suggested not buying any dip to 1255 because I expected that level to fail the next test. Wednesday opened with a sprint to 1272 and the expected failure. 1255 provided support at Wednesday's close at exactly 1255.77 but that support was toast as Thursday's open was a free fall event to 1235. That 40-point drop was a very nice ride and I hope everyone took it.

Next week is not so clear. We are so oversold that any spark could produce one of those monster short covering rallies we have seen so many times before. However, since Thursday was the perfect opportunity for a real rally and it failed the odds of a sudden short squeeze are a lot slimmer. I would look for those critical support levels, 10750, 2100, 1240, to be tested again but after that it is anybody's guess. It just depends on how much stock funds have left to unload. If Friday's decline was just cleanup by those late to the party then we could move into range bound mode as we await the PPI/CPI and Beige Book. Once those reports are opened for the world to see it should determine our market direction. It is important to either follow the trend or watch from the sidelines. The VIX hit a 2-year high on Thursday at 20.75 but you don't need that news to tell you the markets are highly volatile. This is an adult swim only and there are sharks in the water. We had our first fast market day in ages on Thursday as well as trading curbs on the NYSE. A fast market means quoted prices on your screen are not correct because order flow is too fast for the systems and computers to keep up. I had several fills well away from where the price was indicated. If you can't stand the heat stay out of the market. No whining allowed!
 

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