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Market Wrap

Running of the Bulls

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Stronger than expected economic news and weaker than expected inflation powered the markets to gains not seen in many weeks. The Dow and S&P broke two months of overhead resistance to move to three-month highs. The Dow closed higher every day this week, a feat not seen since Sept-2005. The Nasdaq posted its strongest week since April 2004 with a gain of +106 points. On the surface it would appear the markets were positioned for further gains despite the rocky calendar period just ahead.

Dow Chart - Daily

SPX Chart - Daily

Nasdaq Chart - Daily

The only material economic report out on Friday was the Consumer Sentiment for August, which came in at 78.7. This was a sharp drop from the 84.7 seen in July. The expectations component led the drop falling to 64.5 from 72.5 but the current conditions component also fell from 103.5 to 100.8. The drop in the headline number to 78.7 pushed the index to its lowest level since Oct-2005. The expectations component at 64.5 was the third lowest reading since 1992. Analysts said the terror plot, record gasoline prices, fears of a possible expansion to the war in the Middle East, slowing job growth, rising consumer debt, rising interest rates and falling housing prices were to blame for the drop. This seems to follow the Fed's expectations that the economy is slowing and the support from consumer spending will erode. Since the majority of survey responses were received before the end to the Middle East conflict and before this weeks strong market gains and drop in oil prices we are likely to see a sharp jump in sentiment with the next update.

Consumer Sentiment Chart

The drop in Consumer Sentiment sent the markets into profit taking mode early Friday but the selling was short lived as the bad news bulls bought the dip. The weeks economic reports seemed to confirm the Fed's decision to pause the current rate hike cycle and suggested that pause could become permanent. Lower than expected inflation in the PPI and CPI was accompanied by continued slowing in the housing sector while manufacturing appeared to be strengthening. This is exactly what traders wanted and a strong "Fed is done" rally appeared just when everyone thought those were over. Even comments from several Fed heads that the Fed may not be done or dismal Dell earnings failed to deter the bulls.

Dell posted earnings that were nearly cut in half compared to the same quarter in 2005. They also announced the SEC was conducting an investigation into their accounting practices. Their balance sheet is beginning to show evidence of bleeding with cash balances down and receivables growing along with rising inventory levels. Dell pioneered the just in time inventory model and capitalized on consistently lower prices for components by ordering just enough to cover sales for the next 7-14 days and not allowing costly inventory to pile up. This way Dell took advantage of the competition between suppliers and the constant decline in component prices. With current inventory levels rising faster than sales it suggests Dell's sales forecasts were overly optimistic and they are behind the curve. Hewlett Packard is gaining share and Dell has found itself lagging in the PC race. Add in the $400 million laptop battery recall announced last week and the list of problems at Dell is growing. For the last quarter gross margins were 15.54% compared to 18.61% in the year ago quarter. Operating margins fell to only 4.29% from 8.74% and the net margin fell to only 3.56% from 7.60%. Cash fell by nearly $1 billion while receivables rose by nearly $1 billion. Free cash flow dropped by -$450 million to a still healthy but declining $1.3 billion. Dell is down but not out and tech bulls were quick to buy the morning dip. Dell fell to $20.65 at the open but rallied to close at $22.16 and only a -64 cent loss for the day. Dell had previously dropped to $18.95 on the profit warning back on July 21st.

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Google celebrates its 2-year anniversary as a public company next week and its stock price, currently $383, is well above the offering price at $85. Remember Google had to cut that offering price after lukewarm reception to its offering. The high profile antics of the founders, its massive disclaimers in the offering documents and the overall unknown about its profitability discouraged some funds from taking the IPO plunge. The controversial Dutch auction process rather than the traditional IPO method also soured the deal for some investors. Rather than provide financial transparency to pre IPO investors a Playboy interview debuted on the day the bidding began for the IPO. The doubters were proved wrong as the profit machine rolled forward but critics still remain. Many of their high profile product announcements over the last two years failed to follow through on execution and remain a cash drain rather than a profit center. Still Google is number one in online search profits and new deals with web giants like News Corp, AOL and Viacom should keep them there. About the only thing Google has not announced since their IPO is a stock split. Today 20 out of the 28 analysts surveyed by First Call have a price target of $500 or more. Three have a target of $550 and one at $600. Google went public with a market cap of $20 billion and that valuation has risen to $115 billion today. This is more than Yahoo ($39B) and Ebay ($36B) combined. It has tripled its work force from 2292 to 7900 employees and has more than four times the cash in the bank ($9.8B) than it raised in its IPO ($1.6B). It will also spend more on capex in 2006 than it raised in the IPO. Google's "Do no evil" motto rang hollow to many IPO critics but to those initial investors still holding GOOG stock Google can do no wrong.

Microsoft jumped +1.09 on Friday to $25.79 after announcing that its $20 billion, 800 million share tender at $24.75 had failed. It really did not fail but only 155 million investors opted to sell their stock back to Microsoft at that price for a total of $3.8 billion. Microsoft took the unused $16.2 billion and added it to their existing buyback program pushing the total outstanding to $36.2 billion. This will not happen all at once but between now and June 30th, 2011. You can bet Microsoft will use that authorization to keep a floor under the stock during any future negative announcements such as a further delay on Vista. Analysts now see $24 as a bottom and much of the bad news potential already priced into the stock.

There is no bad news for Altria (MO) after Judge Gladys Kessler ruled that although tobacco companies had deceived smokers about the health impact of smoking, she did not have the ability to award substantial financial penalties as a result of the RICO charges. The Dept of Justice had been seeking $14 billion in penalties on charges of racketeering to fund anti smoking programs. This is just the latest in a string of good news events for Altria and the stock spiked +3.22 to a new high after the announcement. In July the Florida Supreme Court ruled in favor of the industry and cancelled the $145 billion judgment given by a jury. With the cloud of damage awards and court actions evaporating daily the future for Altria is bright. MO gained +3.22 on Friday to $83.97 and was responsible for about +20 points of the Dow's gain. This offset the losses by Boeing (-.97 or -5 Dow points) and CAT (-1.05 or -5.13 DP).

Boeing was weak on news that it may cancel its C-17 program due to a lack of orders from the government. This would cost -5,000 jobs at Boeing and -25,000 jobs at suppliers of components.

Ford lost more ground but only fractionally after the sharp drop on Thursday. Ford announced it was cutting production overall by -21% (-168,000 units) and -28% in the F-series pickups. Production will be cut to levels not seen in 25 years. Ford made over 100,000 too many pickups and inventory backlogs are becoming a serious problem. Ford said sales of the $35,000 pickups had slowed substantially with higher gas prices. 75% of those pickups are bought for work use and 25% for pleasure. Prices are too high on all domestic vehicles according to Ford and GM due to rising employee benefits. GM says more than $1500 of the price of each car is related to health benefits alone. The governor of Michigan was interviewed about the expected plant closings in her state. She said there were already more cars manufactured in Ontario Canada than in Michigan due to the lower cost of labor and employee benefits. Ford said it would halt production at 10 assembly plants between now and the end of 2006 to allow surplus inventory to be sold. The combined market share of the big three, GM, F, DCX, fell to 54.5% for the first seven months of 2006. Toyota sold more vehicles than Ford in July making it likely it will be solidly in the big three by year end. GM already announced it would cut production by as much as -8% in Q3. These cuts by Ford and GM are very likely to cut profits drastically at component supplies like Visteon and Lear.

With high oil prices pushing gasoline prices higher the consumer is caught in the middle. Consumer sentiment on Friday proved that. This week may have been the break in that trend. The combination of peace in the Middle East and no storms in the gulf knocked -$7.45 off last week's high of $77.45. The decline to support at $70 was sharp and painful for the oil bulls but not unexpected. We had been waiting for the end of summer decline as a buying opportunity. $70 is strong support but I don't think it is the bottom. Friday saw a rebound of +1.15 to $71.10 on short covering ahead of the weekend. With a low pressure system in the Caribbean some are hoping will turn into a hurricane it was too risky to go into the weekend short. Late Friday the NOAA website said there was little chance of the depression turning into a named storm due to various factors. That means Monday could see the resumption of selling. September crude futures also terminate normal trading next week so the rebound could have been partially expiration related. Gasoline demand is slowing with a -167,000 barrel drop last week. With only two more weeks of summer driving demand should continue to drop and gasoline prices along with it. Also depressing prices was a downgrade of oil consumption demand by OPEC due to a slowing global economy. Our Fed may have paused in its hike cycle but 23 of 28 central banks around the globe are still hiking rates including a surprise hike from China on Friday. BP also announced on Friday that oil production from the west Prudhoe field had returned to 200,000 bpd and could go higher.

Gasoline Demand Chart

September Oil Futures Chart

I attended a weeklong oil conference last week where 80 companies presented their outlook for the future and NOBODY was expecting a significant drop in oil prices. They were even more bullish on natural gas prices calling the current $7 price a half price sale caused by the warmest winter on record. Oil and gas prices were pushed higher in 2005 by the strongest storm cycle on record that was followed by the warmest winter on record. Nobody expects that trend to continue with an eventual resumption of normal weather cycles. Energy companies are rich with cash and paying down debt at record rates while expanding their capex spending and exploration programs. None of those efforts is expected to create a surplus of supply, ever. I am preparing a report from the conference with my analysis of the top 10 companies and the expectations for oil and gas prices. I will leave you with one chart today that shows why prices are going higher long term. The chart was prepared by Unit Corp, the 3rd largest drilling contractor in the United States, from EIA data. The chart shows that in 1970 the industry produced nearly 22 trillion cubic feet of gas from just over 100,000 wells. In 2004 the industry produced only 19.7 tcf from nearly 400,000 wells. This net drop of more than 2 trillion cubic feet from four times as many wells proves without a doubt what I have been preaching for the last two years. The easy gas (and oil) was found a long time ago and companies are having to drill faster, deeper and more often just to stay even with prior production levels. According to Crossroads (XTO) and EOG Resources (EOG) the industry decline rate averages around 30% per year. Without a constant supply of new wells demand would outstrip supply almost instantly. Despite this slowing production demand continues to climb at an alarming rate. Back in the 1970s most electricity was from coal fired plants, hydroelectric and a few gas plants. In the 80s/90s the pollution problem caused a major shift to cheap clean burning gas. After the oil embargo when oil prices spiked to record levels the move away from home heating by oil and electricity accelerated to cheap and plentiful natural gas. I had interests in several wells in the early 80s that were plugged because they only produced gas and nobody wanted it because it was so cheap. Those days are gone forever. Twenty years of shifting to gas for electricity and heating have produced demand that is dangerously high.

Gas Wells versus Gas Production

The demand for gas in a normal winter exceeds our ability to produce gas. To solve this problem distributors have developed the ability to store 3.4 trillion cubic feet in advance of winter. Some say as much as 3.7 tcf can be stored but that extra 300 bcf would have to go into reservoirs, which have not been tested at pressure. In other words they could put it in and have it disappear into some underground fault if much pressure is applied. These storage areas must be filled over the summer months and early fall or we run the risk of running out of gas over the winter. The gas producers and pipelines do not have the capacity to supply gas at the demand rates we use during cold weather. A couple years ago we came very close to seeing pressures in gas lines falling to dangerous levels due to a shortage of gas. Currently there is 2.8 tcf in storage and that is +14% over the five-year average. Baring some unforeseen circumstance we should see record levels of gas in storage around October 1st as storage levels hit their maximum capacity. Backup pressure in the pipelines would prevent further injections at the well sites. That could produce some further weakening of gas prices as distributors stop taking gas from the pipelines due to lack of storage. A hurricane tearing up the gulf would be about the only reason this max storage event would fail to occur. Even if we do hit record levels with high pressure in the pipes it does not guarantee a constant supply throughout the winter. If our mild temperatures translate into a colder than normal winter that 3.4 tcf in storage could be gone very quickly. According to the EIA normal gas consumption in the December-March period is about 2.5 tcf per month. The gas in storage is used to augment the gas produced. According to the EIA the average monthly production for 2005 was 1.52 tcf. Is it beginning to make sense? We burn 2.5 tcf per month during the winter but only produce 1.52 tcf during that same period. That is a shortfall of nearly a full trillion cubic feet during the winter months that must be covered by that 3.4 tcf gas in storage. In a normal winter it is enough to fill the gaps but if old man winter settles in for a harsher than normal visit we are in deep trouble. Also keep in mind that production is falling each year despite a record number of wells. This turned into a lengthy explanation but I think it is important for everyone to understand the problem in years to come.

Gas Production Table

The Dow and S&P may have broken past resistance to new three-month highs but the Nasdaq was the real star. The Nasdaq gained +5.2% or +106 points for the week. The Dow and S&P were tortoises to the Nasdaq hare with only a 2.6% gain. Even the Dell earnings could not dim the tech bull's enthusiasm with a rebound from Friday's opening dip to close at 2163. The power behind the Nasdaq was the SOX with a stunning +9.9% gain of +40 points. This SOX spike to 445 was a clear breakout of resistance at 420 that has held the SOX in check since early July.

SSOX Chart - Weekly

Unfortunately that spike came to a sudden halt at the 450 resistance level that dates back to late 2004. The 450-460 range should be very difficult to break even for the bad news bulls. The Friday dip came after the semiconductor book-to-bill number for July was released Thursday night. The number declined to 1.06 and a four-month low. This was a sharp drop from the 1.14 seen in June. Orders are still +73% above the level for July 2005 and the B-T-B has been above 1.0 for six consecutive months. Bulls may start to wonder if this hiccup is temporary or the sign of slowing orders in a slowing economy. It still makes 450-460 a tough bump ahead. If the SOX is headed for a speed bump we could expect the Nasdaq to produce a rocky ride as well. Resistance from 2165-2185 is going to take some tough bullish conviction to cross.

The same congestion level for the Dow would be 11385-11425 and exactly where the Dow ran out of steam on Friday. However, that Dow performance was nothing short of spectacular with resistance at 11300 dating back to late May finally broken with a strong buying binge. The Dow pulled up to that level prior to the Fed meeting and then consolidated afterwards with a -250 point drop. That drop was overcome quickly once the inflation data turned tame and the Dow added +293 points for the week.

The S&P also turned in a stellar performance with a breakout from the 1280 resistance to knock on the 1300 door twice on Thursday and Friday. The end of day short covering bounce on Friday pushed it to nearly 1302 and a three-month high. I have to admit I am surprised but we were ready to go long with the breakout over 1280 and I will gladly take the gains. With the 1280 resistance behind us and the three-month trading range broken we need to focus on 1295 as our future trend indicator. This was prior resistance, which turned into support on the late week pullback. It should remain support if this rally is going to stick. Remain long over 1295 and flat or short on a failure of that level.

We have a very strong setup in our immediate future. August and September are typically the weakest two months on the market calendar. Hedge funds are net short in anticipation of a normal dip and rebound out of the October lows. At SPX 1300 they should be getting very anxious about those short positions. Those funds who built up cash positions ahead of the normal calendar dip should also be starting to worry that they will miss the rally if they don't act quickly. SPX 1295 is the key. Any failure there should reinforce the normal historical thinking and have everyone setting up for the dip once again. HOWEVER, if the bulls can rally out of the gate on Monday it could trigger another huge round of short covering along with panic buying and a potential bear-b-que. Should we actually break over 1325 and a new five year high it could turn into a rocket ride higher.

Economic Calendar

Next week has no economic reports of earth shaking significance. We have a couple more Fed surveys and home sales updates but nothing that should give the bulls cause for worry. Now that bad economic news is seen as good news for the Fed and the markets any good news could be even better. Those inflation numbers in the PPI/CPI were a license to buy and a sign the Fed was right to move to the sidelines. Thoughts of a recession have evaporated and with falling energy prices and no hurricanes in the Gulf the yellow brick road could turn into an expressway.

Where is the fly in this ointment? Iran is looming large on the horizon and trouble is brewing. Iran had said it would respond to the prior UN offer by August 22nd. Once the UN warned Iran to stop enriching uranium by August 31st their deadline of the 22nd was thought to have disappeared. Either way it is only a week apart and Iran says they have no intention of halting nuclear work. Late Friday there was a flurry of news with various US officials saying the US would waste no time pressing the UN for sanctions if the August 31st deadline was not obeyed. Iran has said that the imposition of sanctions could cause a rise in the price of oil and a wave of terror attacks against sanction backers. Russia and China are against sanctions but you can bet there will be some trump cards played by the US to push them off the sidelines. Something is going to happen soon and without a major concession from Iran involving the loss of significant political stature to the Iranian administration it is not going to be pretty. Because the Iranian administration has been so adamant to the Iranian people that they will never back down it puts them in a volatile position. They will eventually be pushed into a corner and when cornered most regimes are normally dangerous.

This problem may not impact the market next week but a showdown is coming. Instead of trying to anticipate potential problems it is best to simply focus on the trend. Maintain long positions over SPX 1295 and go flat or short below that level until a new support range appears. The bulls are stampeding and pushing the bears ahead of them. Until the bulls tire we want to follow behind them in the safety of the trend. It is easier to follow the herd than anticipate it as many bull runners in the Fiesta of San Fermin, Spain can attest. I want to be a spectator not a causality as we approach those resistance levels described above.
 

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