The market opened lower on Friday after Dell rang the earnings bell before the open with a strong earnings warning. Dell's weakness offset gains in Microsoft and sent techs sliding once again with the Nasdaq closing at a 14 month low. Slowing purchases by both corporations and consumers is producing growing weakness in the tech sector. The earnings picture is becoming clearer and the picture is not pretty.
Dow Chart - 180 min
Nasdaq Chart - Weekly
This was a very rocky week for the markets. The Wednesday short squeeze was quickly forgotten and negativity began to increase its grip on the markets as the week came to a close. Inflation is rising despite hopes from the Fed that it will slow. Economic indicators are slowing and slowing more rapidly than previously expected. Fears are growing that stagflation, a period of rising inflation without growth, is on the way and the Fed cannot do anything about it.
The Fed says inflation will slow as the economy slows but the Consumer Price index posted a +0.3% gain in the core rate for the fourth consecutive month. Core CPI is up +2.6% for the year and over the Fed's comfort level. Bernanke led investors to believe that the Fed was nearing an end to the rate hikes but the CPI suggests they are not yet done. Bernanke indicated again that the Fed was data dependent for future hikes and the data indicates inflation is still rising. The Fed is also counting on an economic slowdown to further depress inflation. As long as inflation does slow along with the economy that would produce the highly desired soft landing. That scenario is showing cracks in the foundation due to high-energy prices, high commodity prices, falling home values and slowing consumer spending. Rising energy prices are rapidly slowing consumer sales and it appears the market is beginning to price in a crash landing.
Based on market reaction you would think the current earnings cycle was much worse than it is. With 30% of the S&P reported 66% have beaten estimates, 20% matched estimates and only 14% missed earnings. The missed percentage was well within normal ranges. The challenge is simply the high profile earnings misses in that 14% and the guidance for future quarters. As you can see in the table below the overall earnings growth for the S&P companies already reported has dropped substantially from just a week ago. The current 14% average should receive a boost next week as most of the energy sector reports. The sector is expected to post better than +30% growth and that will offset slower growth in other sectors.
EEarnings Snapshot Quarter to Date
The markets are reeling under earnings misses and more importantly lowered guidance. Better than expected reports from companies like Microsoft, Google, Caterpillar, Motorola, Nokia and United Technology are being overshadowed by results from companies like Yahoo, Intel, AMD, Capital One, Dell and 3M. The disappointing results from high profile companies are combining with weak expectations in retail, housing and autos to generally sour investor sentiment. Next week should not be any different with the exceptions of earnings from the energy and materials sectors.
Very few companies reporting decent earnings are seeing any benefit in their stock prices. Caterpillar was a prime example with earnings that beat the street by a dime and guidance that was very good. The CEO said business was very strong with record backorders through 2007. He also felt the boom had 2-4 years left to go. They had strong cash flow, better than expected sales, higher margins and raised guidance significantly. What more could you ask for? CAT closed down for the day and nearly -$3 off its highs.
Nucor Steel (NUE) beat estimates by +12 cents and said orders and backlogs across all product lines were healthy and earnings will continue to be "VERY" strong. NUE closed -$6.20 off its Thursday high.
CSX Corp, a leading transport stock, posted earnings that beat the street by 51 cents and was +127% over the same quarter in 2005. They also announced a 2:1 stock split, a 10 cent post split dividend (+54%) and a $500 million buyback program over the next 12 months. They said business was so strong they expected to raise prices up by +6% this year and again in 2007. They did receive some insurance payments related to hurricane losses that inflated earnings slightly but were roughly equivalent to the profits they would have made without the hurricanes. The company said business was booming for as far out as they could see. CSX lost -5.34 from the post earnings spike to Friday's close at $62. What is wrong with this picture? The fears of an economic slowdown and higher oil prices combined to push the entire transport sector lower. Transports hit a high of 4722 after the CSX news lifted the entire sector on Thursday but fell to 4362, or -7.6% to Friday's low, a -360 point drop!
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To put it as clear as I can the market is going defensive as growth slows and inflation rises. Investors are not just afraid of growth slowing in the US but across the globe. China saw its GDP grow by +10.9% in the first half of the year, +11.3% in Q2 alone. The Chinese central bank is reacting strongly to squelch that growth to a more reasonable level. This week they raised the reserve requirement for banks by +50 basis points to curb loan growth. They raised rates by 50 basis points in early July as well. Analysts expect the reserve requirement, currently 8.5% to rise to 10% by year end. By raising the reserve requirement it reduces money available for loans and slows growth. Analysts estimate that each 50-point hike removes 170 billion yuan in liquidity from the banking system. In the first five months of 2006 new bank loans had reached 87% of the governments target for the entire year. Investment in fixed assets rose by 30.9% compared to the target of 18%. Analysts feel current interest rates in China are at least -3% below what is going to be needed to slow growth to a reasonable pace.
China is the number one consumer of raw materials in the world. Any significant slowdown in growth would slow earnings at any company that is selling into that growth. That included companies like Caterpillar and Nucor Steel. The US is the largest consumer of finished goods. If the US is headed for a crash landing or the stagflation scenario then analysts are worried what that would mean for global growth. Currently there is very strong growth in almost every country and a ripple down wave from a crashing US economy could impact that global growth. This is the scenario analysts are painting and investors are fleeing. Defensive stocks like Colgate, Johnson and Johnson and Altria are benefiting from this flight to defensive issues while retail, housing, transports and tech stocks are getting pummeled.
Warnings from the housing sector grew even more negative last week. D.R. Horton (DHI) posted earnings that fell -12% and the CEO sent chills through the sector with his predictions. Don Tomnitz said the current downturn could be longer and deeper than we have all imagined. He said home sales in June fell off the Richter scale accompanied by very strong cancellations. Builders have given up trying to predict the bottom and Tomnitz said "the market is going to get softer going forward and that view is without any rose colored glasses." Analysts are now predicting a 17-20% drop in profits for 2006 and a 47-50% drop in 2007. Housing makes up nearly 25% of the US economy. Ryland also dampened expectations after saying it suffered a drop of -40% in new orders.
Dell shares fell to nearly a five-year low at $19 after cutting its Q2 outlook. Nearly $5 billion in market cap was erased. Dell said aggressive price-cutting and a slowing global market was to blame as well as slowing demand in the enterprise server market. More than 124 million shares were traded. Dell cut its profit estimate to between 21-23 cents compared to 32 cents expected by analysts. Projected revenue was only slightly below the $14.2 billion analysts expected with margin pressures accounting for the large drop in profits. Margins are expected to slide to the 15% range compared to 17.4% in Q1 and 18.6% in 2005. In another marked change from the past Dell elected to NOT hold a conference call to discuss the change in outlook. According to Gartner Group Dell is under pressure from other companies grabbing market share. Sales growth at Dell is rising only +11.6% compared to HPQ +13.8%, Lenovo +13.5%, ACER +34.7% and even Apple saw a +61% rise in notebook sales and its strongest unit sales ever at 1.35 million units. Dell has been able to leverage its low cost model for the last ten years but the law of decreasing returns has finally come home to roost. Other companies have finally mastered the model and the consumer is reaping the benefit. The profit available in Dell's current offering of a 2.5GHZ desktop PC with a 17" monitor for $299 is very slim. Shipping has got to run $50 at least and the Windows XP operating system another $50 bucks even with their volume discount. Add in another $50 for the Intel processor and that does not leave much for the rest of the components. That 15% margin encompasses all their products including the high margin printers, servers and gaming computers. That means they have to be selling those entry-level systems at or near cost as bait to get customers to the website. They hope you will switch once you see the higher priced toys. Unfortunately customers being pressured by high gas prices are buying the entry-level system.
Some financials are also being hurt by disappointing results. Capital One Financial (COF) lost -$8.47 (-9.7%) on Friday after posting results of +1.78 per share compared to consensus estimates of +2.06 per share. The company blamed the drop on fewer late fees as credit card customers paid their bills on time and higher reserves due to worsening credit in its overseas operations. The higher reserve impact to earnings was 16 cents. North Fork Bank, currently being acquired by Capital One, saw earnings fall -9% on a -20% drop in mortgage lending and rising interest rates. Analysts were not scared off and many reiterated their buy rating on COF, most with a 12 month price target of $100. COF closed at $77.71.
Capital One Chart - Weekly
The oil sector and oil prices have disconnected over the last week. Oil closed at $74.40 and -$4 off its high reached last Friday. Much of the volatility was related to the expiration of trading on the August contract on Thursday. The September contract (CL06U) became the front month contract on Friday. Profit taking as the contract expired and on the cooling fears that Iran and Syria would enter the Israel/Hezbollah conflict helped to push prices lower. With Israel poised to invade Lebanon this weekend the price of oil traded briefly over $75 but settled at $74.40. No hurricanes have appeared around the Gulf and supplies remain at high levels. Next week should be a critical week for oil prices as driving demand slows and traders decide what side of the futures trade they want to take going into August. Energy stocks benefited from the short squeeze on Wednesday but the bounce was brief. Stocks appear to be factoring in a fall from $75 oil despite continued analyst projections for $80 before summer is out. We are also seeing traders exit stock positions ahead of next week's energy earnings. After seeing the massacre many stocks experienced this week even after reporting decent earnings it appears traders are taking profits early.
Haliburton (HAL) continued its weeklong post split plunge to close at $30 on more than 50 million shares traded. HAL had been extremely weak since the split for no apparent reason. That reason appeared on Friday as HAL announced it was backing away from an IPO of its KBR unit citing weak market conditions. HAL said it could still do the IPO but it is no longer a first step in the process. HAL asked the IRS for a tax-free ruling on spinning it off to existing HAL shareholders. CEO Dave Lesar said HAL does not want to delay any longer the timing of the KBR separation. KBR has been under fire from several directions and it appears HAL now wants to dump it to avoid future liability. KBR is worth an estimated $8 billion so HAL still wants to extract that value in some form. Investors dumped HAL stock to the tune of -$8 since the $37.93 high last week. Sometimes the best laid plans of mice and men ultimately go astray.
Next week is another strong week for earnings and economic reports. The economic calendar is full but the only really important report is the Q2 GDP on Friday. Earnings will still take center stage and a repeat of this week's results is almost assured with more than 500 companies reporting. The graphic below shows the top 20 winners and losers on Friday.
Table of Winners and Losers
Weekly Internals Snapshot
The internals snapshot for the week shows volume rising into the Wednesday short squeeze and remaining strong for the two days following the rebound when the markets were weak. The lack of follow through and the quick return to the prior levels indicates a complete lack of confidence in the bounce. Note that the 52-week highs and lows had already returned to their pre bounce levels on Friday.
The Dow closed with only a -59 point loss on Friday held up mostly by the gains in MO, JNJ and Microsoft. Microsoft rose +$1 on its $40 billion stock buyback plan. With most of the big guns in the Dow already reported there may be little left in the form of additional earnings support. 3M is the most notable ahead and they report on Tuesday. They have already warned and are trading at strong support at $70. It would take strong new revelations of additional problems to push it much below $70. The Dow is probably going to be a follower rather than a leader next week and the leader will be the Nasdaq. The Dow was weak post bounce but thanks to the defensive issues not as weak as the Nasdaq. The Dow closed at 10870 with 10850 as intraday support. Without peace in the Middle East or a cure for cancer I find it hard to believe we won't retest 10700 next week.
The Nasdaq completely erased its midweek gains and returned to 2020 to close at a 14 month low. With most of the big techs already reported there is little in the way of a positive event in our future. The next support level is 1900 and we could reach that level quickly with a couple more high profile disappointments. The SOX is dragging the Nasdaq lower with AMD, Broadcom, Freescale and Marvell leading the list of losers. The SOX declined to close at 385 on Friday for a -174 drop from its 2006 highs or -31%. The good news is that 385 should be support but it may take a goal line stand to make that support hold.
SOX Component List
SOX Chart - Weekly
The S&P returned to past support at 1240 to wait out the weekend. The bounce to 1262 was quickly sold and the decline to 1240 simply put the S&P back into the bottom portion of its prior range. 1220 remains strong support and 1280 and 1290-1295 strong resistance. This is still well above the predictions by the Hirsch organization of 950 by year end. I believe we will see lower lows somewhere in the 1175 range but it is too hot today for me to drag my bear coat out of the closet for the proper attire to focus on 950. Let's take this one week at a time and let the market tell us where it is going.
It is too early to tell if this post bounce bearishness is just left over selling from the May dump or a symptom of a more serious disease. Friday was option expiration and we definitely saw plenty of options related volatility over the past week. The earnings next week should provide plenty of earnings volatility and we have a nice wide range in which to play ahead of the Fed meeting. Last Sunday I had hoped we would have a directional market by this weekend. The oversold rally I was expecting came right on schedule but its duration was far shorter than I expected. I figured we would have several days of hang time to plan our next move as earnings progressed. That hang time was measured in milliseconds on Thursday morning and it has been downhill ever since. The pause at support, S&P 1240 and Nasdaq 2020 was just enough of a tease to make me think the bulls are still alive and buying the dip. If those levels break on heavy volume it will be time to start backing up the cattle hauler for a run to the slaughterhouse. My bias is now bearish and will probably remain overall bearish until October. I am sure we will have several monster short squeezes along the way but there is little incentive for investors to buy and hold stocks today. After the Fed meeting volume should begin to decline even further as traders try to compress their unused vacation time into the remaining three weeks of summer.
The Fed meeting on August 8th is only 11 trading days away and I believe there
will be plenty of positioning ahead of that meeting in hopes of a Fed pass or
language indicating they are done. Any material dip between now and that meeting
is sure to be bought. I would look to buy the dip for a pre meeting trade but be
ready to bail once the meeting
is over. After the meeting is when the summer
doldrums will really appear. The next FOMC meeting is Sept-20th and after
traders come back from vacation. Try not to trade the post meeting doldrums for
many have tried and few have been successful. After the meeting we want to wait
for the fall buying opportunity during the normal Sept/Oct dip. While waiting on
the Fed you could nibble sparingly on recent gifts from the market. COF and HAL
would be a couple that quickly come to mind. Avoid
trying to catch those falling
knives. Wait for signs of returning buyers.