Various factors combined to produce a very rocky week for the markets but next week could be even more unpredictable. The earnings picture over the last week was rife with warnings and speculation making the impact of the geopolitical news even worse. Next week earnings speculation will fade with hundreds of companies reporting actual numbers. Speculation this weekend is what Israel will do before those earnings releases are made. With increasing risk that Syria and Iran could enter the battle the focus on earnings could pale in comparison with an escalation of that magnitude. It is shaping up as a volatile week unless the conflict fades over the weekend. If that should happen mediocre earnings could be welcomed as a relief by anxious investors.
Dow Chart - 120 min
The economic reports on Friday were less than spectacular and were mostly ignored given the events in the Middle East. Import prices rose slightly by +0.1% due mostly to the increase in oil prices. No surprise there. Retail sales for June slowed only slightly by -0.1% but that was substantially below the expected gain of +0.4%. Auto sales led the decline as gasoline prices slowed interest in buying autos. Ex-autos sales rose +0.3% and nearly in line with estimates. Unfortunately gas stations receipts headed the list of positive components with a +20.4% year over year gain. No other retailing segments even came close to those gains. Business inventories jumped significantly by +0.8% compared to estimates for only a +0.4% gain. The jump in inventories came from slowing sales allowing those inventories to climb. On the positive side business sales rose +1.4%. Also pushing inventories higher was a jump of +3.2% in auto inventories. This skewed the numbers to the upside giving us a lopsided view. Overall inventories are +4.1% higher than the same period in 2005.
Consumer sentiment fell to 83.0 in the first reading for July compared to 84.9 in June and consensus estimates for a rise to 85.5. The second reading in June, comprising survey results from the last half of the month was 87.4 bringing the June final reading up to 84.9. This spurt of positive sentiment was evidently reversed in early July and most likely due to higher gasoline prices. Expectations were flat at 71.6 from the final reading of 72.0 in June. However, present conditions fell sharply to 100.8 from 105.0. This is further evidence it was the impact from the sharply higher gasoline prices depressing sentiment ahead of the holidays.
Consumer Sentiment Chart
The economic calendar for next week is chock full of potholes that could trip up the market. Leading the list is the Producer Price Index (PPI) on Tuesday. Evidence of rising inflation in producer prices would be negative for the interest rate outlook. However, more important will be the Consumer Price Index (CPI) on Wednesday. This will show how much inflation has filtered through to the consumer level and this will be a direct impact to future rates. Just after the CPI is reported Bernanke will appear on Capitol Hill to testify on the state of the economy. He will be grilled relentlessly on current inflation levels and his rate outlook. His record as a public speaker has been peppered with mixed results early in his tenure but late appearances have shown him to be more cautious in his remarks. With the market under attack investors will be looking for any crumbs he may toss that suggest rate hikes may be nearing an end. This testimony on the same day as the CPI has a very good chance of moving the market. He gets to correct any misstatements on Thursday when he appears again to repeat his performance. Bernanke may not want to give the market too much hope and keep the bond groupies guessing. As we saw with Greenspan talking rates higher is almost as effective as raising rates. Other global institutions are also seeing the inflation risk rising with the Bank of Japan raising rates by +25 points on Friday. This may be the time Bernanke will elect to duck the issue as much as possible knowing he will get another entire month of data before he has to make that decision for real at the Aug-8th meeting. We will also get the FOMC minutes on Thursday to show us what the FOMC members were thinking in the June meeting.
The economic calendar has plenty to cause market volatility even without the earnings schedule. Over 400 companies report next week with many of the majors making their confession. After a week of warnings and global events pushing the market lower it may be time for an earnings surprise. Tech has been punished for weeks with the Nasdaq being pushed to a new nine month low on Friday. Nobody expects techs to be positive and most expect the big caps like INTC, MSFT and others to disappoint. This could be a prime opportunity for an earnings surprise that produces a market rally. Remember, very seldom do we every see an earnings rally when investor expectations are positive. Those expectations are already baked into the cake. Earnings rallies appear when least expected and this could easily be the case now. Earnings and guidance would not even have to be good, just not as bad as expected!
Obviously speculating on earnings ahead of next week is just that, speculation. I have been expecting negative results for weeks but so has the market. You might be surprised to learn that 44 S&P companies have already reported. They beat the estimates by an average of +6% with earnings up +31.5% and revenue +17% over the same quarter in 2005. This good news was overlooked by nearly everyone since all but a couple of those companies were small fry and the results were not highly publicized. If this trend continues when the big names report next week the bears are going to be running for cover.
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With the confluence of events early next week the odds of a positive market event are growing substantially. There is still a strong element of risk but only a couple of things have to happen to reverse sentiment completely. As of Friday's close the odds of another rate hike in August had fallen to nearly a coin toss at 52% chance. This is due to the market drop, soaring oil prices and the violence in the Middle East. Analysts think Bernanke will not further penalize the markets with another hike given the current situation. Of course August 8th is still quite a ways off to be counting rate hike chickens. Still there are several events, which could change directions instantly.
Going into Friday's close there was nearly unanimous agreement that Israel would invade Lebanon over the weekend to crush Hezbollah resistance one more time. The preparations they made by bombing bridges, airports and blockading avenues of escape as well as avenues for incoming support suggest they were gearing up to close the noose and sweep through Lebanon on a terrorist hunt. There were fears that Syria and Iran could join the fight but late day commentary suggests Iran had told Syria to lay low and told the Hezbollah and Hamas leaders through their Syria channels to disappear rather than continue pressing the fight. If it appears by Monday that the conflict has cooled rather than escalated then that will remove a major hindrance for the market.
If the PPI and CPI are tame that will also remove a major stumbling block. Add in a dovish Bernanke testimony on Wednesday and investors could begin coming out of their caves. By Wednesday night we should have a much better idea about the quality of Q2 earnings and future guidance. A surprise there in addition to a dovish Bernanke could spark that building bullish sentiment and another bear-b-que develop.
I do realize that is a lot of "If" statements. I was a programmer back in the 60s and all those qualifications would be called nested ifs. If A, B, C, D and E are true then a rally would develop. Unfortunately in market terms there is never a guarantee and there are various definitions of true. Israel may cool but not back down. Bernanke may cool rate hike fears but not entirely. The CPI may not be overtly inflationary but not moderate either. Earnings may be better than expected but guidance may be weak. As an example GE tanked on Friday after beating on revenue and announcing earnings inline with expectations. Guidance was the culprit. They were not as bullish as investors had hoped. This is a very gray area in the earnings cycle where good guidance is simply not good enough to overcome the post earnings blues.
Key earnings events will include Intel, Microsoft, Yahoo, Google and Ebay. Intel announced they were firing 1000 managers in their current reorganization attempt. Most analysts expect thousands more to be terminated with some details released with earnings. Normally cost reductions are met with investor approval but in the case of Intel they may fear the reason for the reductions rather than the benefits. Sales of PCs are slowing and how slow is still a big question.
Microsoft is expected to guide lower based on the delay of Vista. Since Gates rumored last week of further potential delays that lowered guidance could be for several more quarters. I would not morn for Microsoft regardless of their news. I ran across some numbers last week suggesting there are 800 million to as many as one billion Windows PCs in the world. Kicking out a few as servers, some more running pirated software and a few more that are old enough not to qualify as upgradeable you could easily get a number in the 500-600 million range that would qualify for an upgrade to Vista over the next couple years. That represents a conversion base of nearly $150 billion in potential sales. Add in another 100 million upgrading to Office 2007 and that equates to nearly $200 billion in new revenue on just their two basic software offerings. Analysts think there could be another wave of two million new computers ordered from Dell, HP and others, in addition to their normal order flow, once Vista becomes available and the numbers just keep getting bigger. Can Microsoft disappoint? Absolutely! Are they going to quit printing money with the Microsoft logo on the boxes? Heck no. That makes MSFT a buying opportunity on any dip back to $21.50 but it would have to be a very long-term hold. I got off topic with this Microsoft discussion but I thought it was worth a few sentences.
Ebay is expected to disappoint due to whispered reports that item listings are shrinking. If that is true it would be a major blow to the business model. Ebay has been a constant grower although slower than investors had hoped over the last couple years. Any revelations about shrinking item counts could get really ugly. Ebay is already under the gun with the expected drop in PayPal revenue once Google Checkout is running. Google is probably one of the few tech stocks where expectations are still high. Unfortunately there are rumors of cracks in their foundation as well. Google has always promised too much in the form of new offerings and almost always failed to deliver. Most of their recent new product announcements never seem to get out of test mode despite throwing billions of dollars into continued development. There are also rumors of falling ad sales. If Google disappoints there could be real bloodshed. Picking up the Internet pieces is Yahoo. They are expected to beat estimates and show sizeable gains. According to published reports they saw an additional one billion page views due to the World Cup with multiple ad impressions on each one. Over 31 million new video streams were delivered with World Cup content. Yahoo seems to be nibbling away at Google's audience and they may be a bright spot for tech earnings.
Take the drama I described surrounding only five tech companies and multiply it by four hundred for next week. That is the kind of sensory overload traders will be facing. Add in the economic and geopolitical events and the possibilities for the market outcome are unbelievably complex.
The markets imploded last week with drops of -2% to -5% across all the major indexes. The only sector to brave the storm was energy. It was mostly positive but only barely so despite the new high for crude of $78.40 on Thursday night. Israel and Lebanon don't have any oil but there were fears Iran could enter the fray and use their oil card to force world outrage to squelch the battle. That could still happen but it would be wise for them to remain quietly on the sidelines with their nuclear ambitions back in front of the UN Security Council. The spike was also prompted by new attacks on oil pipelines in Nigeria cutting even more production capability and by the -6mb drop in crude inventories in the US last week. Gasoline demand over the July-4th weekend surged nearly +2% over the same week in 2005 despite prices averaging over $3 a gallon in most areas. Gasoline inventories fell -426,000 bbls and refinery utilization dropped -2.6 points to 90.5% due to the closing of the ship channel and associated oil spill. It was the perfect storm for oil prices with supply problems, refinery problems and geopolitical problems with only a real tropical storm missing from the equation. So far the Caribbean/Gulf areas have been quiet but should a storm appear in addition to those other factors above the price of oil could rocket over $80 very quickly.
Crude Oil Chart - Daily
Oil stocks did not generally react strongly to the spike in oil prices. All these events are reactionary and should not impact oil long term unless Iran does something stupid and joins the conflict. Otherwise inventory levels are still adequate and the peak of the driving season has passed. If a storm does not appear or Iran joins the conflict I expect oil prices to ease sooner rather than later. Oil stocks generally report earnings next week and this will give the S&P earnings percentages a boost making them appear stronger than they really are. Energy is expected to produce +32% earnings growth and that will cover up a lot of tech sins in the totals. Energy earnings could be the saving grace for the market next week even if oil prices begin to decline.
The sharp drop in the indexes prompted me to dust off my correction table for further review. In the table below the first column is the Pre June highs and the next to last column is the post May lows. The difference in these gives us the correction percentages for each index/commodity. The highlighted indexes are the indexes with more than a 10% correction and the orange ones are those indexes with new lows last week. The Dow came within two points of making a new low below 10700.
Table of Index Corrections
This table illustrates the grossly oversold conditions in the tech sector. The charts below show that the Friday lows for several indexes were right on strong support. The combination of oversold and strong support would lend credence to the potential for a rebound if at least a couple of our conditions came true. A break below these support levels could give us an entirely new wave down and without some kind of positive earnings news to sustain us it could be a long drop. I have been warning for several weeks that we would see lower lows before October and I still believe that even if we get a temporary rebound next week. It has already happened on the Nasdaq and SOX with the Dow and S&P only a few points behind. Any news event over the weekend could easily produce those new lows on Monday and prime the pump for the rebound I discussed above. Of course all bets are off if the geopolitical situation worsens or Bernanke develops foot in mouth disease. As of Sunday the S&P has gone 845 days without a -10% correction and that is the second longest streak in history. I am betting that this streak is about to end.
Market Internals Table
The market internals on Friday deteriorated despite an increase in volume on the upside. 37 new highs is very weak even after a strongly negative week in the market. The were still 104 new highs on the Friday after the May 11th implosion. New 52-week lows are also accelerating with 7.2% of all stocks listed on the major exchanges at new 52-week lows. That is an astounding figure for a market with supposedly bullish undertones.
The Dow cascaded from the 11256 high we saw last week to 10701 on Friday. That is a drop of -555 points. 10700 should be very strong support, support that previously held on the June test. A break here targets 10200 if not 10000. Any rebound attempt only puts us right back in the middle of the range that has held since late May. There is a lighter uptrend support line not shown on the chart around 10600 but I don't give it much credence if 10700 breaks. The target would clearly be 10200.
Dow Chart - Weekly
The Nasdaq rebounded almost perfectly to retest 2200 only a week ago before crashing back to earth and support at 2030. Both resistance and support are clearly visible on the chart as is the next target if 2030 breaks. A sub 2000 drop would be very damaging to sentiment but 1900 is the next most likely target if we do get another round of tech disappointments.
Nasdaq Chart - Weekly
S&P-500 Chart - Weekly
The S&P is the strongest chart of the bunch. Currently resting on uptrend support at 1225 it has survived much better than the Dow or Nasdaq. This is our best indicator of a bullish undertone to the markets. If that uptrend support fails then a drop to the correction level of 1194 seems guaranteed with an additional target of 1150.
Supporting the S&P are the energy stocks, which represent 12-15% of the total weighting. The gains in energy and materials have balanced serious declines in other sectors like homebuilders. The biotechs had been providing support as well but they cratered this week with a drop in the BTX of -4.1% to strong support at 630 ahead of earnings. The Broker Dealer Index (XBD.x) saw a strong rebound from 190 to 218 and joined with the energy sector to produce strong earnings and strong support. That bubble burst on the 5th and it has been a straight drop back to Friday's close at 198. Lehman, Merrill and Bear Stearns all cratered about the time Crammer was pounding the table on them a week ago. Labranche warned that earnings were going to be miserable due to a tough market and losses in their trading and the rest of the sector, even those only remotely related, were painted by the same broad brush. With market leaders being knocked off one by one any disappointments by the energy sector next week and it will be lights out for the indexes.
I have mentioned the election year cycle several times over the past six months. Historically it projects market lows on the second year of an election cycle with greater frequency for a second term president. When that cycle runs into a Fed tightening cycle the results are even worse. On average the Dow lost -22% from the election year high to the mid-term lows. Add in the shock of oil prices above $75 and you get a witches brew nearly guaranteed to make the markets dizzy. The good people at the Stock Traders Almanac put out an alert last week targeting Dow 8500, S&P 950 and Nasdaq 1750 by year-end. They have a pretty good record when it comes to predictions and they have every conceivable statistic available when it comes to the markets. Even if you don't believe them or even if you do and those targets are not hit, the research suggests lower lows ahead.
My official outlook depends a lot on those conditions I discussed earlier in
this article. A lot can happen to move the market over the next week and none of
it is under our control.
The three-day drop was the biggest loss for any
three-day period since April 2005 and that has produced severely oversold
conditions. I went into the close short index futures and long oil futures just
in case Israel decides to flatten a 40-mile wide neutral zone inside Lebanon's
border or Iran/Syria decided to enter the conflict with more than sharp words.
If nothing happens by Monday morning I will reverse those positions and go long
the indexes and short oil for a reaction
trade as those oversold conditions
equalize on Monday. I plan to be flat or long if the bearish conditions ease and
wait to see what the PPI/CPI/Bernanke/Earnings news produces in the way of
market reaction. I believe we will be directional again by next Friday but that
direction is anybody's guess until a few of those events have passed.