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The clock is ticking down to the end of month FOMC meeting and the daily swings in the market resemble the pendulum on that clock. Positive to negative then back to positive. Support to resistance and back to support as that pendulum swings but always returning to the middle of the range. Today's rally was credited to strong earnings from Federal Express and Morgan Stanley, both of which said the economic outlook was strong.

The following bullish chart has been edited to remove the symbol. The bullish trend over the last two years has not broken over the last month with the rest of the market. It has attracted a lot of money and there are no signs of a letup. While you read this commentary try to decide what symbol belongs to this chart.

Bullish Mystery Chart

The economic calendar was not a market mover today. The only report was the MBA Mortgage Application Survey and a drop to 567.6 from 571.9. This drop in applications was minimal and the headline number was right in the same range we have seen for several months with only a slightly negative bias. Purchase applications were unchanged but refinance applications dropped -2.2%. With mortgage rates on 30-year fixed loans at a four-year high at 6.73% it is not surprising refinance activity has slowed. Adjustable rate mortgages also fell as borrowers fear higher rates ahead. The resetting of prior ARM loans has accelerated defaults as housing prices slide. Foreclosure.com shows more than 111,000 homes in foreclosure across the United States. According to analysts nearly $2 trillion in ARM loans are in the process of resetting from their initial discounted rate to current market rates. As this process continues we can expect even more foreclosures ahead. If the Fed hikes rates as expected next week the flow of home purchases and mortgages will continue to slow and those ARM loans will become even more expensive.

The only other report on today's calendar was oil inventories and there was a surprise in those numbers. Oil inventories rose +1.4 mb compared to estimates of +1.3 mb and right inline. The surprise was in gasoline inventories with only a minimal +300,000 bbl gain compared to estimates for a gain of +1.25 mb. Distillates were also inline with estimates with a gain of +1.7 mb. The drop in gasoline supplies despite a jump in refinery utilization to 93.3% surprised traders. Gasoline demand rose for the second consecutive week and took a sharp jump over the same week in 2005. With only two weeks left in the early summer demand cycle, which ends after July-4th, gasoline consumption appears to be rising despite high prices. I would not be surprised to see a negative number for gasoline next week. The average price for the last seven weeks is $2.91. Refinery utilization at 93.3% is well below the normal 96% to as much as 98.5% for this time of year. This is due to the lingering impact of last year's hurricane damage. There are currently no tropical storms on the National Hurricane Center radar.

Gasoline Demand Table

Oil prices had declined to $68.65 on Monday as the July contract neared expiration. The August contract became the current month today and we saw a strong bounce to $70.75 before profit taking hit just prior to the close. Oil ended the regular session at $70.30 for a gain of +91 cents. Other than the sharp drop in gasoline the other factors driving the bounce were the additional kidnappings in Nigeria and the announcement by Iran. The unrest in Nigeria is already priced into the market but the Iran premium had faded. Iran said they would reply to the incentive package by mid to late August despite warnings that a response was needed immediately. The announcement triggered a round of warnings from the various countries that are party to the incentive process. All reinforced the "weeks" limitation given when the package was initially delivered. It was thought that July-15th was the drop dead date back then and that appears not to have changed. This puts the process back in the limelight and should keep a floor under oil prices. Should a tropical storm appear headed for the Gulf that floor will become a launching pad. Just remember prices normally weaken as the summer closes and gasoline demand begins to slip. Prices then rise again once the refinery shift to the heating oil cycle begins.

The market moving news today was not oil and not economics. It was strong earnings reports from Morgan Stanley and Federal Express. FedEx was the most important since its view of economic health spans the globe. FedEx revenue rose +10% with net earnings jumping +25% over the same period in 2005. Earnings were $1.82 and better than analyst estimates of $1.77. More importantly was the FedEx outlook and they boosted their expectations for the current quarter and the full year. The FDX CEO said, "We remain optimistic about the global economic environment for fiscal 2007," which for FedEx began on June-1st. Total package volume grew by +4% for the quarter. The CEO said on CNBC that India and China were exploding. He quoted a statistic that India had more than 250 cities of 2.5 million or more residents. This also confirms the expectations that oil demand will continue to spike. Since 2000 oil demand in India has risen +12% while China's demand has risen +45%. With economic expansion in India running 3-5 years behind China it is only a matter of time until they reach the demand levels currently seen in China. Population in both countries totals 2.4 billion, India 1.095 bil, China 1.313 bil, and eight times the population of the United States. China is expected to have more cars and consume more oil than the U.S. by 2025 with India 5-7 years behind. Federal Express is in the right place at the right time to profit from this economic explosion. Since the U.S. is the largest consuming nation much of the goods those countries produce will head to the U.S. with FedEx getting some of that business as well. The solid outlook by FedEx calmed many investors who feared the Fed would drive the economy into ruin later this year. The FedEx assurance of strong global economics was comfort food for the bulls.

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Morgan Stanley earnings jumped from $.86 to $1.86 for the current quarter on a +48% jump in revenue. MS jumped +2.46 on multiple upgrades. Profit for the quarter was $1.96 billion and earnings per share at $1.86 was significantly over the $1.45 per share analyst consensus. CEO John Mack said Morgan Stanley was poised to capitalize on the current environment and the best first half in the company's history. There were the obligatory cautious comments about how the market downturn in May/June had impacted profitability and the CFO said it was still too soon to tell. The various MS talkers on the conference call would also not commit to calling the May drop either a temporary speed bump or a fundamental shift in market conditions. Vagueness was the game plan and they carried it out perfectly. The MS earnings helped send the broker/dealer sector higher but financials in general were barely positive. The Morgan Stanley sentiment helped the broader markets in addition to the FedEx news.

Sending drug stocks lower was news that Merck was going to offer Zocor to United Health cheaper than the price of a generic once the patent expires on Thursday. This sent Teva Pharmaceutical (TEVA) and Barr Pharmaceutical (BRL) plunging along with the rest of the generic players. This makes a material shift in policy for Merck and could send some strong ripples through the industry for years. Over the next two weeks Merck will lose its patent on Zocor, a $4.4 billion drug and Pfizer will lose its patent on Zoloft, a $3.2 billion drug. This year will see patents expire on more than $21 billion in drugs and the generic manufacturers were expected to reap substantial profits from the rotation into those generics. If this step by Merck is propagated throughout all the expiring drugs the generic sector is in serious trouble. Merck is expected to give the formula for Zocor to Reddy's, an Israeli drug manufacturer in exchange for payments over the next six months on the generic result. By law this arrangement has a six-month limit. After that date it is a drug pricing war. After today's news from Merck it is anticipated that the cost for generic Zocor six months from now could be -95% lower than current Zocor prices. This is a shockwave not only for generic drug manufacturers and but for pharmacy benefit companies. Those companies will suddenly see enhanced profits from the cheaper drugs. BRL fell -2.54 and TEVA lost -3.33 or -9%. Express Scripts (ESRX) gained +2.32, Caremark (CMX) +1.05, Wellpoint (WLP) +1.63, Medcohealth (MHS) +2.16 but United Health barely budged from its recent decline with a +36 cent gain. UNH sentiment is still ugly.

Not all the stock news was good with Jabil Circuit warning after the close. JBL reported profits that were up +8% but company executives said they were disappointed that they would have to lower forecasts for the rest of the year. Traders lower their stock price in after hours trading. The company said the lowered forecast was due to operational issues in the company's electromechanical operations and certain production and repair facilities in America. Sounds like the classic earnings shell game to me. Warn and then confuse investors with generic reasons hoping they assume it was a one-time event. The CEO tried to push the warning to the back burner by assuring investors that demand remained very strong but he also said they were closing some plants and making layoffs. Strong demand always leads to plant closings, right?

The Dow Transports flew to a +135 point gain on the strength of the FedEx profits. This extended their recent gains off the June bottom to +350 points and put them right back at the 4775 resistance we have seen since April. However, sentiment appears to be improving and this could be the first signs of returning buyers. Today they closed right at the top of their recent range and they will have to break that 4775 resistance in order to provide bullish confirmation. Railroads and even airlines have been playing supporting roles. Union Pacific tacked on +2.65 to close right at strong resistance at $90 and a breakout there could give the sector wings. Speaking of wings Continental Airlines (CAL) added another buck to stretch its five day run to +$5 or +21%. In this rebound AMR added +4 but the winner was US Airways (LCC) with a +8 gain.

Dell broke a seven-day losing streak with a +41 cent gain but the trend is still down. Ford sank to a 14 year low at $6.38 after massive selling on Tuesday at the close. Investors clinging to hope as the new 2007 models appeared finally threw in the towel despite assurance from the Ford CEO that they would return to profitability in 2008. With two more years of pain investors probably figured Ford could drop another $3-$4 before the misery was over. At this rate picking up Ford under $5 in the near future would be equivalent to a non-expiring LEAP. Expiration would only come if they eventually filed bankruptcy.

We are only three days away from the Fed meeting and every conceivable option other than a pass has already been priced into the market. Fed funds futures are nearly 100% for a quarter point hike. Farther dated futures are showing an 80% chance of 5.5% by September and 85% of 5.75% by November. About the only option not factored into the mix would be a 50-point hike next week. Since the futures are already factoring it in long term Bernanke could shake up the markets by taking a 50 point bite now and putting real rate uncertainty into the bond market. It could really through a wrench into the works and possibly negate any further rate increases. Bond yields would spike and the long end would do the Fed's work for it.

The problem with a 50-point hike is the death knell it would represent for the housing market. The jump in housing starts this week with housing sentiment at an 11-year low means higher inventory levels ahead. On the surface this means lower prices and more builder deals. But, higher rates means fewer shoppers can afford to buy. What some analysts failed to take into account today was the continued backlog by some builders. The jump in starts could be just filling those orders or with a 4-6 month completion window builders could be targeting the end of rate hikes with that additional inventory. The falling housing market is widely seen as the leading indicator for Fed policy. If they go too far and really tank housing it would spread to the feeder sectors and could produce a recession. Housing is the canary in the coalmine and right now it is on life support. Hopefully Bernanke will not smother it with a +50 point hike while trying to recover his credibility. Current analyst rate estimates are UBS 5.5% in August, JP Morgan 6.0% by year-end, Lehman 5.75% this year and Nuveen 5.25% next week then 12 month pause and Fed funds futures are showing 5.75% by November.

A positive sign for the markets, especially the commodity markets was a global price increase for steel of +19%. China, the biggest steel maker in the world finally buckled under the pressure and accepted the price increase for iron ore. This is bullish for global growth that demand is strong enough to absorb a price increase of this magnitude. Steel companies led the metal sector higher with BHP tacking on +1.55, NUE +1.59, FCX +1.79 and PCU +2.24. Unfortunately those gains only took most back to near current resistance.

The weekly Investors Intelligence survey showed 35.6% of responders bullish and 35.6% bearish with 29.8% expecting a correction. This is actually bullish because rarely does the bearish contingent overtake the bulls. Historically the acceleration of bearishness to this level is seen as a market bottom. While this is a very generic indicator and one that can take weeks to be felt it is very reliable. It does not mean we are not going to retest the lows or even set new ones but it suggests the bottoming process is well underway.

The rally today was yet another short squeeze driven by the FedEx and Morgan Stanley news before the bell. The advance decline line went from zero to +2763 in the first 20 min of trading. A buy program at 11:00 added another +1250 advancers but that run to 12:15 was the end of the gains. Despite several halfhearted attempts in the afternoon the indexes all declined into the close. It was not a material decline but more cautious profit taking instead. The appearance of a possible bottom may have kept the afternoon selling from being any worse.

Advance - Decline Chart

Dow Chart - 180 min

Twenty-five of the Dow components closed positive with GE, AIG, DIS, T and PFE bucking the trend. DuPont, Caterpillar and Boeing were the leading gainers accounting for nearly +35 Dow points between them. The Dow sprinted above 11100 intraday to a +156 gain but barely kept its triple digit status with a +104 close at 11073. Technically it is above recent resistance at 11050-11060 but just barely. Regardless of which direction it chooses on Thursday it is still in the middle of our expected range until after the Fed meeting. A move higher from here would encounter strong congestion from 11100-11275 and it is not likely to break that band. The summer doldrums are still ahead as is the pothole of the Fed post meeting statement. I could see a move higher on a positive statement but either way we need to get past the Fed before we start predicting new highs, or new lows.

The Nasdaq was very strong intraday with a +46 gain at the highs but that 2150 resistance came back to haunt it at the close. The Nasdaq chart is far less bullish than the Dow despite a historically bullish period ahead. The first two weeks of July typically see the Nasdaq outperform the S&P as end of quarter window dressing and retirement fund flows seem to find their way into techs. The Nasdaq has strong resistance at 2150, 2160 and 2180 on its way to very strong resistance at 2225. Until the Fed has come and gone I would be surprised with any substantial gains.

Nasdaq Chart - Daily

S&P Chart - Daily

The S&P fell short of strong resistance at 1260 with an intraday high of 1258 and collapsed back to near 1250 at the close. Like the Nasdaq the S&P chart is far less bullish than the Dow and continues to be stuck in the middle of its expected range. The Dow is the hero simply because it is composed of big blue chip companies in a period of market instability and high pre Fed volatility. Blue chips are considered to be a safe haven in periods of economic instability. The SPX may be pinned to 1250 for the next week with strong support at 1240 and strong resistance at 1260. Without Fed direction we could see a flat S&P but our direction is likely to come from new earnings guidance. This is earnings warning season and while the MS and FDX earnings today produced a strong reaction any major warnings could produce an equally strong reaction in the opposite direction.

Despite the cautious comments about market direction the internals were very lopsided in favor of the advancers. Note the advancing volume at better than 6:1 over declining volume and advancers 2:1 over decliners. This is bullish but it is also a factor of the morning short squeeze. After the Tuesday decline the bears were setting up for another retest of the lows and everybody was leaning to the downside. The morning surprise had everyone running for cover. Note also the flip-flop back and forth over the last week with huge imbalances in both directions. There is no trend and volatility is still in play.

Market Internals

We are approaching the end of the quarter and the possibility for EOQ window dressing is abnormally high. Funds were blown out of many positions over the last month that cash balances are very high. With quarterly retirement funds headed their way they will want to put that excess cash to work before the quarter is over. With the Fed meeting a two-day event ending on June 29th it is very possible we could see a very strong Thursday afternoon and Friday going into month end. That is of course assuming the Fed doesn't do anything stupid.

Funds have been on a cash diet over the last month according to Lipper. Equity funds received only $10.5 billion in May, down -60% from April. However, money market funds took in $45.5 billion. The reason for this flood of cash is the chart below. It is the current risk free money market interest rate. In times of economic instability it is very comforting to be able to sit on the sidelines while earning the current 4.8% rate. It is also the reason the equity markets are not showing any conviction. Safe money hoards are growing while risk money is shrinking.

Current Money Market Interest Rates

Russell Chart - Daily

For Thursday and Friday I would remain cautious and question any rallies that fail to break 1260 on the S&P. I would target any failure at or below that level to enter new shorts/puts. The Russell rebalance produced a -2.4% decline on Monday as expected and now all the speculators should have their positions established. The bounce today gave those who were slow on the trigger a second chance. Now the index should be neutral as we wait for the June 30th sell off by funds. Late next week we should get some additional declines as some funds try to beat the Friday close and not wait until the last minute. This selling could run headfirst into the end of quarter window dressing so it will be interesting to see how the picture develops. If the Fed sours the party on Thursday that window dressing may be light but a surprise by the Fed could cause a rush into the market that would offset the Russell rebalance momentum. One thing about summer markets there is always an event to worry about.
 

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