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Market Wrap

Wake Me In September

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Yawns were the only thing being traded in the market last week. Volume was so low you would have to go back to the week between Christmas and New Years to find a slower period. The average daily volume across all markets was only 3.643 billion shares per day compared to 4.72 billion over the prior four weeks. The loss of a billion shares per day or nearly 25% of the prior weeks was reflected in the flat line performance of the indexes. The only people making money last week were the commissioned brokers. Next week should start out even worse as the summer grinds to a close.

Market Internals

The economic calendar for last week was devoid of any material news other than the two reports on home sales. Next week's calendar starts out that way with only the FOMC minutes and the GDP revision to attract traders attention on Tue/Wed. That will change with a bang on Thursday and Friday with a flurry of economic news headlined by the Chicago PMI, ISM and Non Farm Payrolls. This should make the first three days even more listless than normal but traders will be anxiously awaiting the end of week data. The ISM and Payroll reports are key indicators of economic activity. Soft landing, hard landing or a resumption of the prior growth trend higher will be cussed and discussed based on those reports with the stage set by the lesser reports on Thursday. Thursday's volume should increase as traders jockey for position based on the expected outcome. Friday's volume will likely be very strong at the open but quickly shifting to catatonic by lunchtime as traders close up shop ahead of the three-day weekend.

Economic Calendar

The two main reports last week on the housing sector were grim with New Home sales falling to 1.072 million annualized units from 1.12 million in June. This was the slowest pace of sales since March 2003. Inventory levels rose to 6.5 months of supply. The sales of existing homes fell to 6.33 million from 6.60 million in June with inventory levels climbing to 7.5 months of supply. This was the highest number of houses for sale since 1993. These numbers will get worse since August is not typically a strong month for sales. I put together the graphic below showing all the relevant statistics on the housing sector. This will also continue to pressure consumer sentiment as the value of homeowner equity is eroded. This sharp drop in the housing sector is the best chance of keeping the Fed on the sidelines. This is why the markets did not implode on the negative news. Bad news is good news to a point.

Home Sales Statistics

The energy sector saw prices for oil drop to $71 on Wednesday as tropical storm Debby turned out to sea and away from the mainland. Prices spiked again on Friday to $73.75 as a new tropical storm appeared in the Caribbean. Tropical storm Ernesto is currently headed directly towards the oil patch and New Orleans. Who says lightning does not strike twice? Next week is the anniversary of Katrina. At its current speed it could impact the coast as early as Friday. This storm track sent natural gas spiking to $7.71 on fears that another monster shutdown would occur in the gulf. Even if Ernesto did not develop into a Cat-5 it only has to move towards the oil patch to have a dramatic impact on supplies. Rigs and production platforms would be shutdown and crews transported to the mainland. Even without any major damage a strong storm can halt production for 6-10 days while everyone is being moved back and forth to safety. After the damage from Katrina everyone will be very cautious and start shutting down platforms and bolting everything down as soon as the track is confirmed across the western tip of Cuba. Last week I showed a graphic for storm frequency and the next two weeks are typically the peak for the season. Once past September 15th we are still capable of seeing major storms but the potential drops away rapidly. So will oil and gas prices if Ernesto fails to cause any material damage. The storm season expectations are already factored into the price and those expectations for another strong season like 2005 are rapidly evaporating.

TTropical Storm Debby

Tropical Storm Ernesto

Gasoline Demand Summer 2005-2006

There are only four trading days left before the sound bites on Iran will escalate substantially. That should help keep a floor under oil prices but that floor could be in the $65-70 range. Gasoline demand continues to remain high with the last seven weeks higher than the same period in 2005 despite prices over $3. The early summer demand destruction due to high prices faded by the end of June. Retailers like Wal-Mart are feeling the pinch but Americans are still filling their tanks.

Chavez was in the news again on Friday. He announced he would be selling 500,000 bpd of oil to China by 2011 and 1.0 mbpd by 2012. Since he is currently buying 100,000 bpd from Russia to cover current commitments he can't make it will be interesting to see if he can make this target. I am sure it will be with the help of China's $1.2 billion investment in the Orinco belt. China will also have to upgrade their refineries since they can't currently refine all that the heavy oil from Venezuela. Chavez also said Venezuela would be buying 18 oil tankers from China to transport the oil and 12 rigs to produce it. China is also on the hook to produce and launch a communication satellite for Venezuela, build a fiber-optic network and 20,000 homes. I wonder if Chavez bothered to look at a map. Shipping oil from Venezuela to China is the single longest shipping route on the planet. It is also one that makes the supply chain vulnerable to a number of possible foes. It is estimated that the route would add up to $5 per bbl in expenses. Since China is not stupid I doubt they will be paying market prices for substandard heavy crude that is quite literally shipped halfway around the world. For China that would constitute a buyers market and Chavez is likely to get far less for his crude than he gets from America, possibly as much as -$10 per bbl. That is a strong price to pay just to join the growing axis of evil. Sound like Chavez has found a serious partner in China. That partnership would probably end suddenly, at least for him, if he tries to nationalize their investments in Venezuela once they are completed. China would not approve of that action and would likely send troops rather than write it off as a bad investment.

Merrill Lynch created a ripple in the energy sector on Friday with an upgrade to buy status on EOG Resources (EOG), Frontier Oil (FTO), XTO Energy (XTO), Pogo Producing (PPP) and Newfield Exploration (NFX). Merrill upgraded those gas stocks ahead of the strong demand seen in winter. 45% of gas is consumed in the three big winter months. Merrill said the Gulf, still hurting from Katrina, could not be counted on to cover the surge in demand during a cold winter. Merrill said a decrease in Gulf drilling and limited pipeline capacity could push prices higher over the winter.

Chart of Oil Futures - Daily

Bernanke gave a speech on Friday that was widely anticipated but instead of being a market mover it was a market damper. The expectations were high for a favorable mention of the economy or interest rates and neither was mentioned. The markets had spiked at the open in anticipation of his speech but slumped when it lacked the meat the market wanted. There was little stock news to maintain trader's interest. Comcast (CMCSA) saw a minor gain after $13.14 billion was pledged from several companies for government airwaves in a current auction. A consortium of Comcast, Sprint, Time Warner and Cox Communications won 129 licenses for $2.22 billion. Analysts think they will create their own nationwide wireless network. T-Mobile License LLC won 125 licenses for $3.89 billion while Verizon Wireless and Vodafone together won four licenses for $2.8 billion. T-Mobile was the most aggressive bidder because it currently has less spectrum than the rest.

XMSR received approval from the FCC to resume selling their most popular radios. This was in time for XMSR to put inventory in stores before the holiday season. Ford (F) announced that Robert Rubin had resigned from the board. This is the third director resignation in recent weeks. H&R Block said it was going to take a 19-cent charge related to its mortgage business. HRB has a large sub prime mortgage lending business and that sector is under extreme stress in the current housing environment. KB Home (KBH) notified the SEC it would be conducting an inquiry into stock option grants. Reportedly CEO Bruce Karatz received $100 million in grants between 1998-2001. His four grants were dated at an annual low, a quarterly low and two others at exact monthly lows. Bruce, your may have to kiss that money goodbye and say hello to your new bunkmate very soon if those were not recorded properly. JP Morgan downgraded the stock saying litigation risk associated with those grants posed a risk to the stock price.

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Home Depot authorized another $3.5 billion stock repurchase bringing their current authorization to $17.5 billion. According to Charles Biederman at TrimTabs corporate buybacks are at a record pace of $3 billion per day in August. Since this buyback binge started seven quarters ago more than $630 billion in stock has been repurchased. More than $116 billion was repurchased in Q2 with the numbers rising even higher every day. Leading the buyback parade were XOM $23.9B, MSFT $19.2B, PG $16.8B, C $13.5B, GE $12.7B and TWX $11.4B. An analyst from S&P cautioned that the massive buybacks were impacting earnings at a rate that investors were probably not aware. When companies buy back stock that reduces the number of outstanding shares and increases their earnings per share. IBM has been the poster child for using this method to make earnings in tight quarters for years. According to S&P the buybacks increased earnings for S&P companies by +4% in Q2. That means a lot of companies received several cents of free earnings that enabled them to meet or beat their guidance in Q2. This artificially inflates the earnings growth rate for the S&P and provides a floor under the stock market. The problem occurs when they quit buying back stock and that will happen eventually. Remove $3 billion a day of purchases from the market and that underlying support could fade quickly. When companies buy back stock rather than invest in new equipment, new business segments and expansion of current lines the opportunity to grow eventually slows. If a company has added 3-4 cents to their quarterly earning through buybacks over the last couple quarters then the comparisons for those same quarters next year will be even more difficult. Some companies buy back stock to cover future option exercises. That puts the stock back into circulation and impacts earnings in the opposite direction. Eventually the earnings piper must be paid and that could come in the summer of 2007.

The markets continued to hold the high ground this week although some small cracks were appearing at support. The weak volume coupled with no real economic news allowed the indexes to fall back to support and we saw several dips slightly below those levels before buyers rushed in to fill the gap. I said rushed in but it was more like an octogenarian with a walker moving slowly to buy the dip. Personally I think just holding the high ground is very positive given the weak volume and our position on the calendar. The underlying strength necessary to do this provides conviction that a Q4 rally will appear and it could be huge.

Most market analysts don't expect that rally to appear until after the September 20th Fed meeting. Everyone expects or maybe I should say hopes that the Fed will confirm its decision to halt the hikes and provide some assurance that there will not be any for the rest of 2006. The Fed never wants to hike in the fourth quarter because it detracts from the holiday sentiment that has consumers happily shopping. As long as the economics continue to show reduced growth and there are any indications of slowing inflation I believe we could get a satisfactory result from the September Fed. A sudden surge in growth or inflation between now and Sept-20th could pull the plug on these hopes. This is why the ISM and Non Farm Payrolls next week are so critical. I should also add the Personal Income report on Thursday. The Personal Income Core PCE deflator is a key indicator watched by the Fed. In the last report for the June period the Core PCE showed inflation growing at +2.4% year over year with a +0.2% monthly average for the last eight months. A dip there would also be a welcome sign for the markets.

The market is not as bullish as it appears on the surface. In the chart below you can see the difference between the top 100 blue chip companies (S&P-100 OEX) compared to the small cap Russell-2000. The S&P-100 has nearly regained its May highs with a steady climb from the June 13th low. The Russell has continued to be stuck in a range near the bottom. Fund managers are clearly hesitant to put money into small caps preferring instead the safety of the defensive big caps like MRK, PFE, GIS, SWY, etc. Until the small caps come back into favor any rally will not last. This small cap aversion is the only real sign of the normal Q3 weakness so far this year. Fund managers try to shuffle their small cap portfolios before the end of Q3 to enable them to buy any October dip and ride those positions through the end of the year.

Chart of S&P-100 and Russell-2000

Dow Chart - Daily

Nasdaq Chart - 15 min

The Dow has rested on 11265 for three days and shows no signs of a continued move higher but these are the dog days of August. Nothing positive was supposed to happen last week. We simply have to wait for the next round of economic news late next week to provide fuel for the market. Likewise the Nasdaq failed to impress traders. After breaking through initial support at 2140 on Wednesday it rebounded off the next support level at 2125 to regain 2140 at the close on Friday. It was simply a lackluster week with a very narrow range.

SPX Chart - 30 min

The S&P gave us a little head fake on Wednesday with a break of 1295 and a dip to 1290 on two decent sell program at 10:10 and 1:30. The break of 1295 was the signal to go short or flat in anticipation of a retracement headed our way. The pre-open news on Thursday saw the indexes gap open once again and although the S&P tried another dip it was met with decent buying despite the low volume. After wandering most of Thr/Fri in a very tight 5 point range we saw it pinned at the close right to that 1295 support. Having the SPX pinned to our long/short indicator at 1295 will cause us grief as it trades on both sides of the line multiple times during the day. The best course of action today would be to move the trigger point to 1290 now that 1295 has become the center of attention. If you are not already short I would move my decision point to a break of 1290. I would want to be long over 1300 and short under 1290. That gives the SPX a 10 point range to wander while we wait. Remember also that the economic calendar is heavily weighted to Thr/Fri although we could see some positioning on Wednesday. I would look for Mon/Tue to be like the last couple days unless some news event triggers a move. Economically that could be a surprise dissention in the FOMC minutes or a large change in the GDP. For me I just want to get past Labor Day and hopefully find a post holiday trend to follow until the FOMC meeting on the 20th.
 

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