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Market Wrap

Kick the Cat

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The rally from Tuesday's lows was the biggest Dow gain since April 2005. All indexes surged on significant short covering after the Bernanke speech. While the talking heads are all rattling on about how the market found its bottom I think caution is in order. Somebody needs to kick the cat to see if it is alive otherwise Thursday was just a dead cat bounce.

Dow Chart - 180 Min

Nasdaq Chart - Weekly

Economic reports for the week were benign despite continued signs of rising inflation. Those signs were no worse than expected and they only guaranteed another rate hike in late June. The market was already expecting it and we got a small relief rally that it was not any worse. The only economic reports on Friday were the current account deficit at -$208.7 billion, no surprise, and the Consumer Sentiment at 82.4. The sharp jump in sentiment was a surprise with analysts expecting only 79.0. The present conditions component jumped even more sharply from 96.1 to 103.1 and far outdistancing the one point gain in the future expectations component. Consumer sentiment had fallen -8.3 points in May primarily due to the rise in gasoline prices, weakening housing market and the drop in the stock market. Several analysts felt the sharp gain in June was simply a snap back from the May drop while others felt the May drop was due to a statistical error and the June numbers corrected it. Whatever reason pushed the headline number higher it was a positive factor for Friday's markets.

Economic Calendar for Next Week

Next week the economic calendar is rather slim with no major reports capable of really moving the market. Every report should not stray far from the prior month and all eyes are going to be on the Fed meeting the following week rather than the eclectic group of reports on the calendar. The PPI and CPI last week were the keys for the Fed and the Fed funds futures are showing nearly a 100% lock on another quarter point hike.

There were nine public speeches by Fed officials last week with three by Bernanke himself. He is widely credited with some of the Thursday bounce after comments on energy but I doubt that was the real push behind the gains. On Friday we heard from Kohn, Kroszner and Poole. Kohn told a Boston audience that cutting inflation could be difficult and costly if it is allowed to gain a foothold. He also said widespread expectations of rising inflation can be self-fulfilling. Kroszner told a crowd that the Fed needs to always be looking ahead for future implications of current actions rather than looking in the rear view mirror. He also said the potential exists for current high energy prices to pass through to the consumer in the form of inflation. This is a break from the party line as most of the Fedspeak has suggested impacts from energy should be contained due to a slowing economy. Bernanke himself said on Thursday that the impact of energy prices would be manageable. This was one of his comments that was thought to have contributed to the market rally. Poole said on Friday that the Fed must persist in fighting inflation to prevent it from taking hold. Also, current inflation was outside the Fed's comfort range. This should be the end of speeches from the Federal Open Mouth Committee until after the meeting on the 28th. Next week begins the normal quite period before the meeting.

All of these speeches were seen to have been telegraphing continued Fed moves rather than a coming pause. Fed funds futures are now pricing in a 60% chance of another quarter point at the August 8th meeting to take us to 5.50%. There is also growing support in the futures for another hike before November. While most brokers are keeping their estimates at 5.5% as the top Lehman came out on Friday saying they expect a 5.75% top with a cut shortly thereafter. These rising estimates will continue to pressure the equity markets as investors manage fears of higher rates and a slowing economy.

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The economic calendar next week will be light but it will be replaced with anxious waiting for earnings guidance. We have started to see the warnings appear but the pace should begin to pickup next week. In the past week Carnival said that higher fuel costs and a sluggish Caribbean market reduced profits for the quarter. CCL still beat analyst estimates by a penny and CCL gained +2.02 for the day. Oracle told investors that revenue was +25% higher than the $3.88 billion in the year ago quarter. Oracle had previously guided analysts to +13% to +17% growth. Oracle gained only +49 cents. Not all the early guidance has been positive. Adobe warned that results for the quarter and year would be below current estimates. On Thursday Adobe said Q2 profits fell short of its own projections but the stock rebounded late in the day. Adobe warned last month that results would come in at the low end of estimates. Caterpillar reiterated its $50 billion revenue target by 2010 and expected a +15% to +20% annual growth rate to that target. This helped the equipment stocks and commodities on Thursday. CAT said 2004 was the best economy in 20 years and although 2005 slowed slightly it was still an excellent year and 2006 is expected to be on par with 2005. KB Homes warned Q3 and Q4 revenue to be "well below Wall Street forecasts" but the stock gained +37 cents. KBH said the housing market would remain challenging for the rest of the year and reduced the number of homes they expect to sell to 40,000 from 42,000. Apparently investors feel all the bad news is already priced into the builders.

Overall the number of warnings has been few and the reactions minimal. It was felt that most stocks were already severely oversold and no further damage was possible. That was last week and next week could be a different story. If warnings accelerate and some big names start surprising the street it could easily get ugly again and very quickly. Currently analysts are not expecting a difficult quarter so some unexpected surprises could sour that view. Intel is widely expected to miss earnings and lower guidance and Microsoft is also expected to have a tough quarter. If any of the big guys suddenly start appearing in the news headlines you should increase your caution level.

Next week could also be challenged from another direction. The Russell indexes are rebalanced each year at the end of June. The list of changes was posted after the market close on Friday and will be effective after the market close on June-30th. However, now that the deletions are known they will be sold beginning with the market open on Monday. It is not that the index funds will race to dump shares but everyone else hoping to profit on the June 30th change will short them immediately. Just deleting 185 or so stocks from the Russell-2000 index is not the only downward pressure on index. Russell will also be adding 21 new IPOs that now qualify for addition. Some of these IPO stocks have very large market caps like MasterCard (MA) currently at $3.37 billion. Russell states that the total market cap for the Russell indexes will increase from $14.3 trillion to $15.3 trillion after the rebalance, a +7% increase. Bear with me here as I try to explain how that will impact the market. According to Russell, funds worth $3.8 trillion are indexed to the Russell. This means that roughly 7% of the $3.8 trillion or $266 billion in index share value will have to be sold to make room for purchases of the new companies being added. This is a VERY broad explanation and does not take into account all the various methods for investing in and/or managing a fund tracked to the Russell indexes. It is also based on the entire Russell-3000 not just the R1K or the R2k. Russell ranks the top 3000 stocks by market cap which are eligible for inclusion in its indexes. The top 1000 become the Russell-1000 index and the bottom 2000 become the Russell-2000. A company like Mastercard will go into the top 1000 and that will push some other company out of the R1K and back to the R2K. That means funds indexed to the R1K have to sell the deleted company and buy Mastercard. Funds indexed to the R2K will have to sell other stocks and buy the stock dropping from the R1K into the R2K. Since a stock being pushed out of the R1K has a bigger market cap than any of the R2K stocks it requires an downside adjustment to all R2K stocks currently held. Trust me, the Russell rebalance is a giant headache for fund managers. Any portfolio shifting or hedging before June 30th will exert downward pressure on the indexes since only the deletions or reduction in position size counts towards index movement until July 3rd. Any buying of Mastercard or the 236 other companies being added on June-30th will have no impact on the indexes prior to July 3rd.

I will summarize this as briefly as I can. Roughly 189 companies are being removed from the Russell indexes and selling by speculators will begin on Monday morning. Furthermore, fund managers will have to reduce existing positions by something around -7%, which includes those being deleted as well as those being reduced to make room for the $1 trillion in additional market cap of companies being added. The vast majority of liquidations will not occur until June-30th since index funds are only charged to track the index not anticipate changes. Some will anticipate and try to game the change but the vast majority will not. Still, hedge funds and individuals will start shorting the deletions and buying the additions on Monday morning in hopes of capitalizing on the rebalance.

Link to stocks being deleted:
http://www.russell.com/us/Indexes/US/Reconstitution/recon_deletions.asp

Link to stocks being added:
http://www.russell.com/us/Indexes/US/Reconstitution/recon_additions.asp

Another challenge investors are likely to face over the next several weeks is market cap rotation. In times of rising interest rates and economic slowing it is typical for investors, especially funds, to rotate out of small caps and into big cap blue chips. Small cap companies are usually impacted more by rising interest rates since they borrow more and debt in a slowing economy is a drain on profits. Since nobody knows what is really ahead for the economy other than a projected slowdown we are going to see investors become more defensive. Moving into dividend paying blue chips for the next few months will be a strategy many will follow. If the economic correction is brief they will jump back into smaller and more speculative stocks on the first economic upturn. If the Fed goes too far or the economy slips into recession then they are already in the relative safety of blue chips and collecting their dividend checks while they wait for a rebound. This market cap rotation is already underway to some extent and will likely accelerate as this earnings cycle progresses. The pace of earnings warnings will likely dictate the pace of rotation until earnings are over. Investors are stubborn and most will refuse to bail from their speculative positions until after the earnings are announced. Regardless of how many times companies tank on the earnings announcement investors continue to hold over the event hoping for that jackpot that occasionally appears. Wise investors bail a couple days before earnings content to take the routine profits on the build in expectations rather than routine losses on post earnings reality. One of the most frustrating events in trading is to be holding profitable calls on a company that is tanking in after hours and you can't get out until tomorrow's open and watching those profits turn into losses. The next most frustrating thing is to be holding those calls on your favorite stock when a different company in the sector misses earnings and the entire sector tanks in after hours taking your profits down with it.

Energy stocks rose from the dead on Thursday with very strong gains across the board. The gains held on Friday with very little erosion despite an intraday drop in crude to $68.80. Oil inventories on Wednesday confused the picture with a draw of -1.0 mb in crude but a sharp jump of +2.8 mb in gasoline. Refinery utilization also jumped by +1.7% to 92.7%. It means the floodgates are open ahead of the July-4th weekend and gasoline is pouring into the system. The demand table is showing slightly less demand than in 2005 but it did increase +5% over the prior week. Demand is averaging only about 67,000 bbls per week below 2005 but some heavy usage weeks are just ahead. The average price for gasoline over the last six weeks has risen to $2.92 or +70 cents over the same time last year. Higher prices have produced less consumption but only slightly. The longer prices stay at this level the acceptance of those prices will improve. Ethanol hit an all time high of $4 per gallon in the cash market this week. Any questions why gasoline prices are rising? Did you know that gas mileage from ethanol blended fuels is lower than gasoline alone by -5% to -8% depending on the strength of the blend? Mileage on E85 vehicles is as much as -25% less than gasoline alone. Yes, you are paying more and getting less.
http://www.fueleconomy.gov/feg/noframes/20392.shtml

Gasoline Demand Table

Crude Oil Chart - Daily


Friday was options expiration and it occurred with barely a whimper according to the closing levels on the indexes. Much of the impact had been felt over the last week leading up to the actual expiration. We saw monster volatility and very high volume as positions were closed or adjusted. The average daily volume for the last four days was 5.995 billion shares making it one of the busiest periods on record. Note in the table below the 16:1 up to down volume on Thursday and nearly 4:1 advancers to decliners. This was the mother of proverbial short squeezes heightened by the expiring options. Everyone short on Wednesday going into the quadruple witching was caught off guard by the sudden reversal with time expiring rapidly. Note also the reversal of fortunes on Friday despite the minor losses on the indexes. Sellers showed up in volume but they were not able to take back the gains from Thursday. If you are looking for a silver lining to Friday's cloud that was it.

Table of Market Internals

Index Correction Table

The rebound for the week came after some new lows were logged on Wednesday. Many analysts are calling Wednesday a bottom but a few professional traders are not betting on it. They feel Thursday's rebound was the product of a severely oversold market, option expiration and a well timed buy program combining to produce a short squeeze bear-b-que. The Dow rambled for a +345 point rebound and came to a stop right at resistance of 11050-11060. This is right in the middle of the expected range of 10700-11300 we could see over the next several weeks. Dow 10700 was strong support and a perfect place for the bears to give up prior to OpEx. Friday's -0.64 Dow showing was actually bullish given the +345 point rebound. The gains held under strong declining volume. Chalk that one up for the bullish case. It would also match the big cap rotation scenario I laid out earlier with the smaller cap indexes Nasdaq -14 and Russell -8. Yes, compared to the Dow the Nasdaq Composite is a smaller cap index. Need more proof? The S&P-100, the bluest of the blue chips was only off -1.41.

The Nasdaq rebounded +83 points (+4%) from its Wednesday low of 2065. The dead stop just below strong resistance at 2150 was followed by a -14 point decline. It was a bullish rebound but far from being confirmation of a new bull market. That 2150 level on Monday will be exactly downtrend resistance from where the May-9th decline started. Even if the Nasdaq manages to find additional traction the resistance only grows stronger as it nears 2200. The Nasdaq also has strong resistance in the form of earnings worries from Intel, Microsoft and quite a few other major techs that have been strangely quiet heading into the warning period. If a couple of those large names pops up with a surprise warning then overhead resistance will be even more difficult to break. Of course the obvious question arises. If everyone is expecting Intel and Microsoft to warn/miss would it actually be a surprise? Could just getting it over with actually be positive for the market? It would not be the first time a warning cleared the air. It is the unknown that bothers investors the most.

The S&P-500 ran out of steam at 1258 on the Thursday spike and that is exactly in the middle of the 1255-1260 resistance band. It is also right in the middle of our recent range where biases tend to evaporate. The S&P hit a low of 1219 on Wednesday and only 25 points away from the 1194 level needed for a -10% correction. Heck, that is close enough for me given the decline from the 1327 high but I don't make the rules. If we do roll over below 1260 next week I would expect that 1194 level to be reached.

S&P-500 Chart - Weekly

The market declines have not dampened any bullish spirit by the noted market strategists. In a CNBC poll of top money managers the average target for the S&P before year-end was 1359. That would be a +8.5% gain from Friday's close but there is a catch. Nearly everyone expected lower lows before that level was reached. If you are a student of market history then you know summers are not noted for bullishness and the Aug/Sep/Oct period is know for market bottoms. October is know as the bear killer month because of the number of market bottoms seen during those 31 days. This brings me back to my market projections I have been making over the last couple months. Despite the low last week and the nice rebound I still expect the S&P to trade in a range that is flat to down until later this summer. I do believe the highs are in for the coming months but I do expect new lows. My range target is 1175 as a potential support level for summer but we could bleed down to 1150-1165 and long term support. I still expect the upper range to be 1295 but would be very surprised to see it again in the near future. You can see that gives us plenty of room to wander and I think we will need it. I suspect we will spend most of our time wandering in the middle but opposing forces are very strong and we could see spikes to extremes on either side.

Russell 2000 Chart - Daily

For next week I would look to short or buy puts on any failure below S&P 1260. One way to do this and capture the Russell rebalance volatility would be with the IWM, or Russell-2000 Ishares. The July puts would be cheap and plentiful but a quick check shows others had the same idea. Nearly 300,000 puts traded on Friday with the largest volume of 105,000 at the money. That leaves the Russell futures as the only pure play left. The other option would be to pick a couple stocks from the Russell addition or deletion list from the links above and buy calls on the additions and puts on the deletions. Hint, the bigger the market cap the more buying you will see on the additions. That would target MasterCard (MA) or Burger King (BKC) as big cap entries. There are others but you will have to scan the list to find them. Next week is devoid of any scheduled events that could produce positive results so be on guard for any unscheduled events like earnings warnings that could sour sentiment fast. While everyone would like to think that the bullish sentiment from Thursday would carry over next week I would want to see high volume confirmation before entering any new long positions from this level. It is summer, a week before a Fed meeting, Russell rebalance notice week and the first week of the earnings warning cycle. Anything is possible but for me the risk of downside far outweighs the upside possibilities.
 

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