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Okay, Now What?

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The Fed met, the markets moved and the analysts have argued over the future outlook. Investors appeared to cheer the decision but overhead resistance held. The market's narrow range for the last two weeks was broken but only barely. Inflation is rising, the economy is slowing and earnings are shrinking. Historically this is a negative for the equity markets but a halt in a Fed rate cycle is generally seen as a positive. Confusion over the market's future reigns as we enter the low volume summer doldrums period.

Chicago PMI Table

Economics on Friday were mixed but the lead report, the Chicago PMI, showed a sharp drop in the headline number. The number for June came in at 56.5 and well below the May reading at 61.5 and the consensus estimates at 60.0. This report showed a stronger drop in economic conditions than other recent indicators. As you can see in the table above new orders fell sharply by -12.4 along with a drop in production and employment. The only major gain was the +12.1 jump in prices paid. At 89.0 this is the highest level in 18 years. It is a solid indication of rising inflation working its way through the system. 74% of survey responders reported rising prices. The PMI knocked the morning markets back to negative territory after a strong GM inspired open.

The NAPM-NY rose to 394.5 for June compared to 388.6 in May. Business conditions in New York continued their steady post 9/11 rise. The headline number has been on a steady climb with the last minor blip back in Sept 2005. The six-month outlook at 75.0 is at the highest level since April 2005. Inventory used in production fell by -19 days but this is a volatile component that averages between 45-60 days so this drop just brings it back into line with the averages. The capital expenditure days fell for the second month but the 360 we saw in April was abnormal. The average is around 175 days. The internal production components are all well over 50 indicating economic expansion. Note the purchase quantity at 72.2 has taken a sharp turn higher from April's 37.5. Not shown here is the continuing job losses in manufacturing and financial services. Many businesses are reporting moves out of Manhattan to reduce expenses.


Consumer Sentiment

The University of Michigan Consumer Sentiment for June rose to 84.9 from the preliminary 82.4 reading. The present conditions component rose from 96.1 to 105 and expectations rose to 71 from 68.2. May was a low point for sentiment after a decline from 91.5 in December. The combination of high gas prices, falling stock market, weakening housing market, rising rates and constant talk of a slowing economy was more than consumers could bear. June's rebound shows the resiliency of consumers and their adaptability to higher gasoline prices. After two months of $3 gas it has become factored into daily life with cutbacks in driving or expenditures cuts in other areas. The next shock to sentiment could come when gas hits $3.50 later this summer as some analysts expect.

Personal income for May was released with a +0.4% headline number. This beat expectations of only +0.2% and represented a +5.4% rise since May 2005 but was still below the +0.7% seen in April. As you might expect that +5.4% increase over 2005 was still below the +6.7% increase in spending over the same period. Not surprisingly the savings rate fell by -1.7% to its lowest level since August and the second lowest level on record if you count the hurricane dip last year. The PCE Deflator, an indicator of inflation at the consumer level also rose +0.4% pushing the 12-month number to +3.3%. The core PCE, minus food and energy rose only +0.2% or +2.1% year over year.


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The economic calendar for next week contains two major reports. The ISM Index on Monday is the major economic indicator for June. This will show on a national level where we stand in terms of an economic slowdown. The index is expected to be relatively flat at 54.9 compared to 54.4 in May. Given the potential for a surprise we could see some added volatility. The markets close at 1:PM and morning volume is going to be extremely light once the opening Russell settlements fade. Any material surprise in the headline number could produce a significant market move given the expected low volume. With expectations flat a surprise could come from either direction. The ISM needs to remain over 50 to indicate a continued economic expansion.

The Jobs report on Friday will be the next milestone on the economic highway. Expectations are for a gain of +175,000 jobs but you may recall the May report with the same expectations only managed to produce +75,000 jobs. Whisper numbers are running around 135-150K but it is entirely possible we will see something under 100K once again. At some point a falling labor market is going to impact the equity markets negatively. Housing accounts for 25% of the jobs in America and many builders are suffering heavy layoffs. Two builders here in Denver, a relatively strong market, just cut their workforce substantially. With condo construction going dormant and home inventories at a 6.5-month level there is no need to maintain the fast pace of construction seen over the last several years or maintain that level of workforce. Add in the job cuts in the automotive sector and the attrition from the $1.7 trillion in mergers and acquisitions so far in 2006 and I see weaker job numbers not inline with estimates. Note in the table below how badly analysts have missed the estimates over the last year.

Jobs Table June-2005 to June-2006

Economic Calendar

The news moving the markets on Friday morning was a Kirk Kerkorian move to form an alliance between GM, Nissan and Renault. Apparently KK had discussed an alliance with Renault CEO Carlos Ghosn and Ghosn expressed an interest in acquiring up to a 20% stake in GM. Renault owns a 44% stake in Nissan. KK owns about 10% of GM at prices averaging around $29. KK had bought into the company 12-18 months ago when he thought a bottom was forming and then suffered substantial losses on the continued drop. He exited some positions on the way down and then added to positions around $20. Using his activist clout he has been able to push GM stock higher and Friday's gain of +2.35 pushed him much closer to breakeven. If he can get the automakers to do a deal it would represent a $3 billion buy in by Renault/Nissan. That would push the stock price higher and give KK more clout against the GM board. The alliance would be a joint working arrangement not a merger. The companies could share production and design facilities and reduce costs and redundant product lines. Those at Burnham Securities familiar with GM management said the deal had a "snowball's chance in hell" of ever occurring. GM is right on the verge of completing its turnaround and announced last week it is two years ahead of schedule on job cuts. Ghosn is nicknamed "Le Cost killer" after he took Nissan from being in debt for billions of dollars in 1999 back to profitability in 2001. It appeared to some analysts that KK may be trying to undermine GM CEO Risk Wagoner and setup Ghosn to take control of GM. Wagoner is already on shaky ground and offered to resign in April unless the board gave him a vote of confidence which they did. The KK proposal may not have a chance in its present configuration but odds are good he will keep pushing until some arrangement beneficial to his share price is concluded. The +2.35 gain in GM represents roughly +20 Dow points and kept the Dow from closing any more negative than its -40 point loss. The next largest gainer was Merck at +54 cents.

Apple Computer lost -1.70 after admitting that they had an option grant problem and had hired outside counsel to do a review. This adds Apple's name to a growing list of companies who apparently played with the dates to give preferential treatment to officers in their stock option grants. This list currently involves more than 60 companies but there are still some roaches in the woodpile. Computer Associates (CA) announced on Thursday it may have to take a charge of as much as $300 million in additional expenses for option grant misdeeds.

Computer Sciences (CSC) was crushed for -$7.32 after it revealed the SEC had requested information about its stock option grants. In an effort to blunt the news CSC said it was going to buy back up to $2 billion in stock. Also hurting them was news that they were no longer exploring merger possibilities. Those hoping for a long awaited takeover rushed for the exits.

Palm reported earnings that beat the street but was knocked for a -2.56 loss on weaker than expected guidance. I believe this is going to be the market killer as the earnings begin in earnest on July 10th. The number of warnings we have seen plus the weak guidance from many late reporters could accelerate once the regular earnings cycle begins. Now that the quarter is over there could be an increase in warnings.

August Crude Oil Chart - Daily

July Unleaded Gasoline Chart - 30 min

Oil prices posted gains for the 8th consecutive day as increased gasoline demand pushed prices higher. The expiring June contract in unleaded gas hit a high of $2.32 on Thursday but was hammered back to $2.11 at the close as traders exited ahead of Friday's expiration. Oil closed at 73.93 for a gain of +41 cents after a strong break of initial resistance at $73 on Thursday. The $74 closing level is also strong resistance from June 5th and a break there could easily see a new high before the late summer slump. Analysts are expecting gasoline prices to hit $3.50 as demand outstrips refinery output over the next couple of weeks. There is plenty of gasoline in inventory so there will not be any shortages. Current refinery problems on the gulf coast and in the rain-swollen northeast are expected to be resolved by next weekend.

Also pushing prices higher was a new deadline imposed on Iran. Initially Iran was asked to respond by June-29th but Iran said it would not respond until August 22nd. That gives them more time to refine uranium before saying take this proposal and shred it. US Under Secretary for Political Affairs, Nicholas Burns, said the committee had given Iran until Wednesday July-5th to respond and comply with the terms to stop any enrichment currently in progress. The committee spokesman is scheduled to meet with Iran on Wednesday. The US said the committee was unified around the offer and the timetable. Diplomats from the world's eight major industrial nations said at a Moscow meeting on Thursday they expected to receive a "clear and substantive" response by next Wednesday. Iran has had the proposal since June 6th and the committee feels any further delays are just stalling tactics. I seriously doubt Iran will agree and will stonewall again. Iran's foreign minister reaffirmed on Thursday President Mahmoud Ahmadinejad's position that Iran would NOT reply until Aug-22nd. A senior Iranian cleric, Ahmad Khatarmi, vowed on Friday that his country would never talk with the US over Tehran's nuclear program. On Tuesday Iran's supreme leader, Ayatollah Ali Khamenei, said he saw no use in talking with the US. He further said, "with regards to our nuclear case, we have nothing to do with the U.S. and principally, our officials will have no talks with the U.S." He said Iran was only willing to talk with European leaders on the committee "if they recognized Iran's right to pursue nuclear power." The UN committee said it was going to meet on July-12th to either consider Iran's response or make decisions on the next step in the sanction process if Iran did not reply. The leaders of the entire G8 +1 countries, Canada, Italy, Japan, Russia, Britain, France, Germany and the US, plus China, are scheduled to meet on July 15th in St Petersburg, Russia. The committee is nearly powerless unless Russia relents and signs on to some further action. On Tuesday Putin said, "I repeat once again that we have no intention of joining in any kinds of ultimatums that only drive the situation into a dead end and deal a blow to the U.N. Security Council's authority." On Thursday the text of that speech was presented to the committee to emphasize that point.

With or without Russia I expect this problem to escalate over the coming weeks and that could keep oil prices at the current levels despite inventories at the highest level in eight years. Oil inventories have risen +39 mb over the last 90 days despite another drop of 400,000 bpd in Saudi production and 500,000 bpd offline in Nigeria. Iraq is finally producing 2.5mbpd and security appears to be holding around the oil infrastructure. Inventories in the US have been increasing at an average of 496,000 bpd despite a drop in imports of -448,000 bpd. Current crude inventories are +10.7% OVER the five-year average and refinery utilization rose to 93.8% last week. This is the highest level since Katrina. Without a meltdown in Iraq and a string of hurricanes headed toward the gulf oil fields there is going to be a price correction soon. Depending on Iran and the weather I expect that August, if not earlier, will see some strong volatility in the price of oil. Gasoline demand increased ahead of the holiday weekend but inventory levels are right at the five-year average and driving is expected to slow after the holiday due to higher prices. The crack spread jumped from 20 cents on June-20th to 42 cents without any specific reason. This sets the gasoline market up for a fall once demand slows.

Gasoline Demand Table

I was shocked by the market rally around the Fed meeting this week. Program trades were prevalent the morning before the meeting announcement and then again after the announcement. Shorts were squeezed again and the trading range for the last two weeks was shattered. When you look at the Fed statement there is only a VERY slight modification that could be seen as a softening in their stance but the market seems to have interpreted it as a guarantee. Sorry folks, but it is not a guarantee. The Fed has clearly said they will continue hiking rates based on the data. Friday's data clearly showed an increase in the inflation rate with the prices paid component of the PMI hitting an 18-year high. Wake up and smell the inflation! I am not going to beat a dead horse here and the next meeting is August 8th. We will see how long the current attitude remains in the market. With the ISM and Jobs next week it could be severely tested.

The Dow ran for +335 points between the Wednesday low and Friday high. Friday's action was lethargic at best after the PMI knocked the props out at the open. Volume was very low until the 3:PM bell marked the beginning of the Russell rebalance. As of 3:PM only 3.4 billion shares had traded across all markets. Between 3:PM and the close of after hours trading nearly 4 billion shares traded hands. That is more than we traded all day on Monday. Friday marked only the second 7 billion-share day in market history.

Market Internals

The reason for the extreme jump in volume was the Russell rebalance at the close. According to an interview with Russell officials on Friday over $3 trillion is now indexed to the Russell-1000/2000 indexes. Nearly every position had to be modified in some respect with the index weighting for each stock being adjusted due to the additions/deletions. The index peg is tied to the closing prices on Friday so the majority of funds submitted market on close orders to change these positions.

I have to admit this Russell rebalance did not go as I planned. I had shorted Russell futures at the close just before the announcement and got a good ride down on Mon/Tue the next week but that was the end of the free money. The market rebounds on the 21st and 26th gave us new entry points but there was never any real momentum to the downside. I shorted it again on Friday afternoon and finally thought we were going to see a collapse into the close but a monster buy program hit at 15 min before the close and took out my trailing stops. After that buy program there was a ton of volume on the buy side with some orders holding 200 or more contracts. This pushed the futures back to 728 after the close when the cash market closed at 720. One trader I heard was speculating that funds took short positions before the June 15th announcement knowing there would be a decline into the close when the had to adjust their Russell positions on June 30th. Once their adjustments were done they closed their insurance in the futures. In theory I understand it but 693 was the futures close before the announcement with a high of the week at 702 the day before. Even if they had anticipated the rebalance and shorted at the absolute high the Thursday before the announcement they would still have suffered a major loss at Friday's close. After the buy program blew through at 3:45 the futures were resting at 723. That is a -20 point loss if they actually sold that level. ($2000 per contract) There were 100-200 contract orders flying by. There were 37,900 contracts traded between 3:45 and the futures close at 4:15. That was nearly 25% of the volume for the entire day in a 30 min period. The majority of that volume was buy orders. The futures spiked +8 points into the close while there were massive order imbalances on the sell side on the Russell changes. Many stocks had imbalances of more than a million shares to sell at the close. Some over 3 million to sell and Exxon (XOM) had nearly 10 million shares sold at the close. Why the Russell futures would be so oppositely imbalanced with 30,000 contracts to buy is a puzzle we may never unravel. I doubt I broke even on the Russell scenario over the last two weeks. Remember what I said last Tuesday about no guaranteed trades? There are no guaranteed trades and this proved that point. It had worked so well in the past but as they say, "past performance is no guarantee of future results." Once it becomes a trend there are always those who will bet against it.

Russell futures chart - 5 min

Dow Chart - 120 min

The Dow rallied out of Wednesday's low at 10900 to trade at resistance of 11200 for much of the afternoon on Friday. That +300 point sprint stopped right at that resistance level, which begins at 11200 and tops at 11275. The combination of end of quarter window dressing and Thursday's short squeeze did a number on the bears. A failure to break that 11275 level next week could result in another lower high and a possible continuation of the correction started in May. The bears will probably try to reload on any attempt to break 11275. However, there are few events next week to stimulate any strong buying ahead of earnings. The ISM on Monday could cause a market move on low volume. Which way it might move is another question. If the ISM drops sharply will traders buy the dip thinking it is an end to future rate hikes? OR, will the sell it on worries that a sharp drop means the economy is headed for a recession? If the ISM turned sharply higher would they buy that news of a stronger than expected economy or sell it fearing more rate hikes ahead? Over the last 45 years covering 10 rate hike cycles the Fed pushed the economy into recession five times. For the other five times the markets sprinted higher by an average of +15% over the following year once the final rate hike was in place. Obviously a 50/50 chance of betting wrong is not good odds in the investing arena. Another study claims 8 of the last ten rate hike cycles produced recessions over the next six months after hikes ended. You can twist survey results any number of ways if you have an answer you are trying to fit. It depends on your definition of recession and the time frame you are using. I believe this cycle should produce the rally when hikes end.

Bond buyers have appeared around every corner. After a two week pounding and the worst 9-day selling streak in years the Friday buying pushed that yield back to a two week low at 5.138%. The yields on the 2, 5 and 10 year are all below the current Fed Funds rate. The bond market appears to be telling us that inflation/recession fears are growing. Several analysts speculated that the lack of a 50-point hike meant the Fed was not ready to really take that final stand and knock inflation backwards. Instead they were willing to wait and see how much further it would climb before stronger action needed to be taken. Indecision by the Fed is never a confidence builder for the markets. The dollar was also pounded on the Fed action and analysts are betting it will continue to fall next week. Gold jumped +27 on Friday to $617.50, +$35 since Wednesday nights close. A cheaper dollar means higher priced gold and oil. The commodity does not change, only the currency used to price it.

Ten-year Yield Chart - 60 min

Dollar Index Chart - 90 min

The Nasdaq rallied very strongly on Thursday as those normally short tech stocks into the summer were forced to cover once again. The Nasdaq posted a +64 point gain and that was on top of a strong bounce on Wednesday afternoon. Resistance at 2180 held and the index closed fractionally lower on Friday. All in all I think that was very bullish. A +90 point rebound in two days and it only gave back two points. You may have noticed in the market stats table at the beginning of this commentary that only one index lost ground for the week. That was the SOX. The SOX never fully recovered from the Tuesday beating to an eight month low at 423. Tech stocks and especially chip stocks are not out of the woods yet. Microsoft has already joined the losers list with its notice about Office 2007 being delayed in addition to Vista. Apple has its own set of problems along with Dell, QCOM, CSCO, EBAY and others. Intel found some buyers last week but almost everyone expects them to warn or miss earnings. It is going to be tough for the Nasdaq to find any traction when the majority of the big cap techs are stuck in quicksand and slowly sinking. About the only techs with a pulse are the Internets, YHOO and GOOG. Even a +3.75 bounce by RIMM and positive showings by several biotechs could not rescue the index on Friday. I think resistance at 2180 is going to be tough to break and tech warnings could be out in force next week.

Nasdaq Chart - 60 min

SPX Chart - 90 min

The S&P made it all the way to 1275 before gravity slowed its advance. That was a +37 point rebound and like the Nasdaq it only gave back a couple points at the close. The resistance at 1260, which had held for two weeks was broken on the Thursday afternoon short squeeze. SPX 1275 has been resistance in the past but not the recent past. The index split the 1260-1290 resistance levels and may have established the upper end of a new range. If not the resistance band between 1290-1295 is much stronger and should slow any pre earnings creep.

I think the rebalance confused the issue on Friday and investors fresh off either wins or losses on Thursday afternoon did not want to take a new position ahead of the potentially chaotic close. The indexes traded in a very narrow range intraday and on very light volume. There was zero conviction but there was an underlying bid. For next week I would be cautious until the Russell cloud disperses. Monday, normally an extremely light day, was blessed with the ISM and cleanup of the Russell positions. That suggests volume will be heavy at the open and then take a direction from the ISM. If the numbers are even close to the expectations volume will die and everybody will leave for the weekend before the 10:00 coffee cools. I would not suggest any new positions on Monday unless you are very brave or a glutton for punishment. Once investors have a chance to really think about the Fed statement and the ISM we could see a directional move begin on Wednesday. My bias just looking at the charts would be short term bearish. Even if we are going higher we should pause to regroup somewhere below Friday's close. However, there was that underlying bid on Friday and a failure to give back any gains. I don't want to count out the bad news bulls. This is their time to shine if they are so inclined. The bears will be shorting the open expecting a pullback and a couple buy programs could send them back to the sidelines in a hurry. That makes Wednesday our day for directional decisions. We could see some companies try to hide their earnings warnings by releasing them on Monday afternoon when nobody is watching. Others facing an early cycle earnings date will be forced to confess quickly now that the quarter is over. The wishing and hoping for a late quarter revenue miracle has passed and final numbers are in the can. This possibility for warnings next week could be our market driver beginning on Wednesday. I am not going to formally pick a direction but my bias is bearish given all the factors. The ISM is Monday's wild card and it could produce an early fireworks display or go out a dud. Plan your market holiday accordingly.

Market Holiday - No Monday newsletter!

Remember, Monday is only a half-day with the equity markets closing at 1:PM. Volume will be extremely light with most traders absent and institutions closed. Because of the expectations for an extremely slow day after 10:15 we are not going to publish a newsletter on Monday. Happy 4th and eat a hotdog for me.

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