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Market Wrap

Holding Pattern

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The markets continued to languish in a holding pattern as we await the FOMC meeting next week. Were it not for the big energy mergers announced before the bell there would have been nothing for the markets to focus on for Friday. The equity market indexes remain stuck in the neutral zone ahead of the Fed but bonds continued their eight-day bull run. Economic reports released on Friday continued to show a slowing economy creating even more uncertainty about the coming Fed decision.

Economic Calendar

The only economic report on Friday was Durable Goods for May which fell more than expected by -0.3%. This followed a much more severe -4.7% decline in April. New orders ex-transportation rose +0.7%. Back orders rose +0.6% and inventories rose +0.4%. Orders for individual sectors showed gains in machinery of +2.3%, computers +1.9% and communications equipment of +5.9%. The highly volatile civilian aircraft sector saw a -17.9% drop. That is totally dependent on order flow at Boeing and that can fluctuate by several billion dollars per month and should be ignored in reference to the other sectors. The drop in aircraft orders was solely responsible for the drop in the headline number. The rise in back orders was the 6th consecutive monthly gain and back orders are up +20% from a year ago.

The +0.7% rise durable goods orders ex-transportation showed more economic strength that the reports we saw earlier this week. The CFNAI on Thursday fell to -0.16 and the lowest level since the hurricane drop in Q4. Weak job gains and rising jobless claims also suggest a weakening economy. The Leading Indicators released on Thursday fell -0.6% for May with only three of the ten components showing gains for the month. The six-month annualized growth rate dropped to -0.4% and the first negative number since June 2001. Industrial production for May also fell -0.1% when a +0.2% gain was expected. The Fed will consider all these factors when it meets next week. The bond market has been very strong for the last two weeks with yields on the ten-year rising to 5.22% from 4.95%. The near vertical rise is due to the weakening economic indicators and the growing potential for a 50-point hike.

Ten-Year Note Yield Chart - 30 min

For the first time in recent memory there is significant disagreement as to what the Fed might do. Yes, I know there is always the hike/no hike question but this time it is worse. There is a growing number of analysts expecting a possible 50 point hike. But, due to slowing economic factors there is also a growing contingent who feel the Fed could surprise everyone with a pass. Remember, Bernanke did say that the Fed could take a pass even if the data warranted a hike. The Fed itself said in the minutes from the last meeting that they did not know if they should hike 50 or pass. If the Fed thinks the economy is slowing and on track to reduce inflation by itself then they could pause to watch another month of data. However, the majority of analysts expect another 25-point hike followed by another 25 points on August 8th. This sets up mass confusion in the markets because nobody knows which way to place their bet with three potential outcomes. There was an economic study a while back that showed inflation normally peaked 6-9 months after the economy peaked. Since we have pretty good indications that the economy peaked in the first quarter that targets an inflation peak later this year. This should not be lost on the Fed since one of the authors of this study was Bernanke.

The CEO of Liquidnet, a large block institutional trader for institutions and hedge funds, said activity had slowed to a crawl with nobody making any big bets. This is borne out by the tight range and lower volume we saw in the markets this week. He said fund were sitting on huge amounts of cash and were showing no interest in placing bets ahead of the Fed decision. He also said the funds were waiting for a market direction to appear. Many funds were cautious and expecting another leg down in the market. With major corrections seen as a -20% drop they feel we are only half way. The CEO said most funds had lost their gains for the year in the May crash and that made them less inclined to take a risk that could put them into a losing position for the year as summer volatility progresses. Most were not even planning on window dressing for the end of quarter due to the convergence of events clouding next weeks forecast. He said many hedge funds had June-30th redemption periods, which required higher cash levels for withdrawals. This interview was an insightful look into what is really happening in the fund mindset. The average Liquidnet trade is more than 50,000 shares worth more than $1.15 million. Most of their trades are matched with other buy side institutions and never make it to the exchanges. This prevents impact to prices since other market participants never see the trade. There are currently about 9000 hedge funds, 2000 new ones opened in the last year, managing $1.6 trillion in assets. Can you imagine if all those funds were trading directly into the market without the benefit of the large block middlemen? We know that more than 70% of current market volume is from program trades and more than 30% is fund related and that is in addition to party-to-party trades by companies like Liquidnet.


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The big news of the day was not the economic reports but the acquisitions in the energy sector. Headlining the news was the $16.4B acquisition of Kerr McGee (KMG) by Anadarko Petroleum. That was not enough for APC, which also announced the $4.7B acquisition of Western Gas Resources (WGR). The KMG buyout represented a +40% premium to Thursday's closing price. The WGR acquisition represented a +50% premium. In a smaller deal Energy Partners (EPL) won the battle to acquire Stone Energy (SGY) for $1.4B beating a competing bid by Plains Exploration (PXP). The Anadarko acquisitions sent both KMG and WGR soaring with each posting better than an $18 gain for the day.

The big question throwing the energy sector into turmoil was why did Anadarko pay such a big premium? Street analysts were scratching their heads wondering why recent acquisitions were valuing companies so much higher than the current street prices. It is very simple if you think about it. The people running these big exploration and production companies KNOW without a shadow of a doubt how hard it is to continue growing reserves. There has not been a major new find since the early 1980s. Every day that passes sees another field go into permanent decline. Every new discovery is harder to find and harder to produce with a lower payout despite higher prices. The politicians (EIA/IEA) claim there is another trillion bbls of undiscovered oil but nobody can find it despite a thousand holes drilled each month. It is one thing to guess about potential undiscovered reserves but quite another to try and turn them into gasoline. It is a perfect example of theory confronting reality and reality always wins.

These large companies are simply finding it easier to buy reserves than find them and despite the price paid for Kerr McGee it only amounts to $12 a bbl for their proven reserves. With today's average cost of a newly discovered bbl at $28 and another $8-$12 to get it from below ground and into a pipeline these companies with existing reserves are a bargain. It is the only way for the major companies to replace their reserves and continue growing. Unfortunately it does not add to overall global reserves. It simply subtracts reserves from one balance sheet and adds them to another. For the world to benefit these companies need to actually find new oil and that is becoming harder to do every day.

Every recent acquisition including the big $36B Burlington acquisition by Conoco @ $18 bbl was criticized as buyers paying too much. With oil holding at $70 a bbl those acquisition costs look like a bargain. Energy analyst Bruno Stanziale with Societe General said it was a great deal for APC given his $85 target for crude before the year is out. APC said it planned to hedge 75% of the acquired production through 2008 using three-way collars that provided a substantial return on investment at the floor price while allowing for significant upside if prices continued to move higher. APC also said it would sell off non-core assets of the combined companies to further reduce any debt incurred in the acquisition.

APC expects to produce 705 mboe from the Western acquisition at a recovered cost of less than $10 boe. They expect to produce 3.1 billion boe from the Kerr McGee deal at a total cost of $12.40 per boe. BOE means barrel of oil equivalent. Since a large portion of these reserves are natural gas the BOE descriptor normalizes the value to a cost per barrel. Roughly 6000 cubic feet of gas equates to one barrel of oil. For me it was a deal made in heaven. You acquire $10 billion in 2005 annual sales, probably $12 billion in 2006, hedge 75% of it at $70 a bbl through 2008 with an acquisition cost of $12. Sell off the non-core assets for several more billion and end up with 3.2 billion bbls of reserves you did not have before worth $192 billion at $60 a bbl. How many companies would love to buy $192 billion in known assets for $21 billion and pay for the majority of the cost by hedging future production through 2008? Add in the undiscovered assets from their current leases and the deal gets even sweeter. Everybody is a winner!

The sudden realization that energy company evaluations were well below current stock prices sent investors scrambling for bargains. Big winners were UPL, $8B market cap, +5.82 and EOG, $15B market cap, +3.92, both strong gas producers. The race was on by analysts to predict the next acquisition targets. Since Kerr McGee was $16.4B everyone under $20 billion came under scrutiny. The names making most of the target lists are listed in the table below. Even Devon Energy with a market cap of $24.5 billion was rumored to be a potential target. If the majors, Chevron at $130B market cap or Conoco at $108B decided the pool of dance partners was shrinking Devon would be a likely target given the majors favor larger scale enterprises. For a major to buy a company as small as Cabot for $2B it would hardly be worth the effort. Buying a small company would be worth the effort for somebody like EOG or DVN who might want to start bulking up to move themselves higher up the food chain.

Potential takeover targets

Oil prices held firm at just under $71 as speculators used the acquisitions as confirmation that the industry expected prices to move higher over the long term. A tropical depression is said to be forming east of the Bahamas but is not expected to develop into anything that would threaten the oil fields. The gulf picked up another +3% of production that had been shut in since Katrina leaving only 9% still offline. I am surprised oil prices are holding at this level with gasoline supplies 600,000 bbls above the five-year average. Add in 1.8mb of ethanol to be blended just before delivery and that jumps to 2.4mb above the five-year average. Crude oil inventory levels are 35mb or +11% above that average. The prices are holding because of Nigeria, Iran and fear of another strong hurricane season. Eventually the prices will begin to slide towards an August low if no hurricanes develop in the Gulf and Iran does not heat up. I expect that slide to begin after July 4th.

The energy acquisitions did not help everyone with major warnings coming from Six Flags and City National. Six Flags (SIX) lost -25% of its value after warning that prior projections would not be met and it was putting six of its twenty-nine parks up for sale including its flagship Magic Mountain park in California. Analysts were quick to distance themselves from SIX after the company said it might be in violation of its bank covenants.

City National (CYN) warned that earnings per share could fall as low as +1% growth compared to expectations of +8% to +10%. The problem is slowing deposit growth as customers switch funds to higher yielding money market accounts and withdraw cash for other uses now that the home refinance ATM has run out of cash. If you remember the interest rate chart I showed on Wednesday night you will understand the rate pressure on these banks. When they have to pay more than 5% to compete with the money markets it lowers their profits since interest rates on loans have not risen as quickly. Unionbancal (UB) and Comerica (CMA) were cut to a sell by Merrill Lynch on similar rate concerns. CYN lost -$7.71, UB -3.20 and CMA -2.14. This pressured the entire financial sector although the larger banks like Citigroup and Wells Fargo have yet to feel similar pain due to their broader base and product offerings.

Build a Bear (BBW) warned that earnings would be at the low end of its prior expectations due to lower than expected sales. BBW lost -$4.49 or -17%. Tektronix (TEK) lost -2.27 or -7.5% after posting decent earnings but giving lower than expected guidance. S&P upped TEK to a buy from hold despite the lowered guidance.

The transports tacked on another +35 points on Friday thanks in part to Old Dominion Freight Lines (ODFL). ODFL said it expected earnings nearly +25% higher than prior guidance due to a +17% increase in LTL tonnage for the second quarter. ODFL gained +2.69 with the good news pushing FDX up another +1.56.

The combination of weak but level economics, fear of the Fed and a mixed earnings picture with both positive and negative warnings kept the indexes flat ahead of the weekend. There is simply too much confusion about the Fed direction and at this point about Q2 earnings for traders to feel good about buying the bounce from the prior weeks lows. The indexes all traded in a tight range for the week and ended mostly in the middle of that range.

The Dow is stuck at 11000 and can't seem to get away on the low volume. The intraday bounce did not hold and it ended with a -30 point loss. Wednesday's short squeeze bounce was completely erased but there was no credible effort to push it below 11000. It appears the buyers are content with waiting at that level for the Fed meeting to begin. Initial support remains 10930 and resistance at 11060.

Dow Chart - 30 min

Nasdaq Chart - 30 min

The Nasdaq, like the Dow, remains pinned to 2125 with initial support at 2105 and resistance at 2150. The few tech warnings we have seen were partially offset by strong earnings from Oracle and expectations about the Microsoft and Intel announcements coming on Monday. It is still early in the tech warning cycle and investors are still cautious. The SOX has also flat lined between 445-460 with chip warnings taking the excitement out of last week's bounce.

The Russell-2000 has maintained an upward bias all week with a close at 690 and appears to be giving Russell speculators a second chance ahead of next Friday's rebalance. It is going to be a tossup between possible post Fed window dressing and rebalance selling but baring a Fed surprise I am betting on a decline into Friday's close. The S&P remains trapped between 1240-1260 and without volume this is where it is likely to stay until the Fed meeting passes.

SPX Chart - 30 min

Market internals

Note in the market internals above that volume declined into the weekend with Friday unable to break 4B shares. This is a far cry from the 6B-7B shares we saw over the last couple weeks. The market is trapped in a holding pattern while we wait on the Fed. The Advance/Decline line was almost perfectly flat on Friday but I did notice an increase in new lows and a decrease in new highs. This is not a good sign and suggests a negative bias to the market despite the flat range.

For next week I would advise going fishing rather than trying to trade the market. Volatility will likely increase but the range may not. This produces a very choppy market that wears down traders and extracts money from their accounts. There is a good possibility that the Fed decision is going to surprise quite a few traders. The potential for a 50-point hike or even a pass could really shake up the market. If we did get a 50-point hike I would buy any material dip. This could be seen as the last hike with the Fed going into neutral while waiting for the summer economy to pass. If we get a pass I am neutral for market direction. There would probably be an initial bounce but investors may fear the Fed is not in tune with the times and continue to worry about future hikes. It is odd but this is one time I believe the markets would rather have a 50-point hike than a pass. With that said a 25-point hike might not give the markets any consolation with the futures already pointing to something in the 5.75% to 6% range by year-end. It will be entirely up to the statement to calm the markets or give them indigestion.

Market/Sector symbols

I received several emails after I changed the market stats graphic last weekend. Readers asked for the symbols for the various market and sector indexes. The table above lists the ones I am using. Unfortunately all the different charting programs and quote systems will require some tinkering to get them to work. Some will not recognize the dollar sign and some will not want the X appended to the symbol. Experiment with them until you find the combination your chart program wants.

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