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Market Wrap

Traders Celebrate A Goldilocks Spring

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The markets celebrated Friday's "just right" economic reports and new highs were made across all the major indexes. The Goldilocks economy appears to be experiencing the euphoria of spring and there are no clouds on the horizon. The bulls continue to frolic and feed on the mountains of buyout cash currently shrinking the amount of available stock to buy. The bears are being forced to eat their shorts on a daily basis despite the short interest on the NYSE and margin loan balances still at record levels. As Friday came to a close nobody wanted to be out of the market in hopes one of their companies would announce a takeover on Monday. It is a scenario for traders to love and lets money managers sleep at night.

Dow Chart - Daily

Nasdaq Chart - Daily

Leading the list was the ISM Manufacturing report for May with the headline number of 55.0 and the highest level of activity since April 2006. The September through March decline into contraction territory appears to have ended. Momentum appears to be growing and that was somewhat confirmed by the strong jobs report. The individual internal components failed to show any specific surge producing an even clearer picture of sustainable growth rather than a random spike. Expectations had been for a slight decline in the headline number but a slight increase in new orders and a drop in prices paid surprised analysts. New orders at 59.6 now stand at levels not seen since Feb-2006. This entire report was encouraging for the bulls since it confirmed a rebound in manufacturing to a 12 month high but still a rebound that was progressing at just the right speed.

ISM Chart

The May employment report surprised everyone with a gain of +157,000 jobs compared to estimates for a gain of +138,000. April jobs were revised down from 88K to 80K bringing the total reported net job gains to 149,000 and closer to the estimates. The unemployment rate remained near its cycle lows at 4.5%. The labor market continues to absorb workers displaced by the housing slowdown and analysts are now expecting employment trends to improve by year-end.

Personal income for April fell by -0.1% compared to estimates for a +0.3% gain. This was the first dip into negative territory for income since the accounting anomaly we saw back in Aug/Sep 2005, which was caused by Katrina. The decline in April was caused by a -0.4% drop in wage and salary income. The good news was a corresponding drop in the core PCE deflator to 2.0% inflation year-over-year. This is the first time since March 2006 that inflation has fallen into the Fed's comfort range of 1.5%-2.0%. This suggests the Fed has no reason to hasten either a rate hike or a rate cut and should be content to watch from the sidelines for the rest of the year.


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Consumer sentiment for May rose +1.2 in May to 88.3 despite a very slight downtick in late May. If the current housing/fuel problems can't dent confidence then better times must be ahead. The expectations component showed this with a gain of 1.7 points. The strong jobs report will help boost sentiment for June.

Friday's economic reports were about as good as it gets. They showed moderate growth and more importantly moderating inflation. The bond market appears to be correctly predicting the direction of Fed rates with the yield on the ten-year rising to a ten-month high of 4.95% at Friday's close. That new high is very close to the problematic 5% rate that tends to weigh on stocks. With yields over 5% bonds become an attractive alternative to equities with no risk. However, with equities rising 1-2% per week there is little chance of a sudden flight to safety in the bond market. Let the equity market cool for a couple weeks and bonds over 5% may become a more attractive option. The Fed Funds Futures for November are only suggesting an 8% chance of a rate cut for the rest of the year. The Fed rarely moves rates at the December meeting so it is a non-event for rate speculation. With expectations for any Fed move at nearly zero the bond market is doing the Fed's work for them with real rates rising to levels where further economic growth should remain constrained. The two wild cards for the Fed today are still the housing slump and gasoline prices. With real rates rising it is putting even more pressure on homebuyers already cautious about buying homes in the face of daily headlines warning of continued problems. Mortgage applications fell -7.3% last week and this should be the prime home shopping season. While the Fed worries that housing could eventually cripple the economy the price of gasoline continues to rise. High fuel prices reduces discretionary income and produces a corresponding drag on the economy while pushing inflation higher. It is the economic conundrum for the Fed but for the bulls it was just economic noise.

The global liquidity wave is continuing with takeovers and buybacks being announced daily. The pool of available stock is shrinking daily while cash levels are increasing. It is a classic short squeeze but not the kind of squeeze you think. The increasing amount of cash is chasing a decreasing quantity of stock creating a stock shortage. When you consider that better than 50% of all stocks you would not buy on a bet and another 30% are marginal that leaves the best 20% being chased higher. Complicate it with massive buyback programs like the Wal-Mart's $15 billion announcement and IBM's $12.5 billion and companies with deep pockets are competing for the available outstanding stock. Companies are even going into debt to buy back stock and that always makes me scratch my head in wonder. I thought debt was the enemy of profits with that interest clock running 24/7 365 days per year. IBM is going to borrow $11.5 billion to complete its $12.5 billion buyback. With rates moving higher debt service on $11.5 billion would probably fund a more favorable dividend increase for years to come. IBM was rewarded with a credit downgrade as a result. Do you think investors will remember the bounce in stock prices caused by the buybacks when earnings fall due to higher debt service? I doubt it. Investors are always motivated by what corporations are doing for you now and not last quarter. At least IBM knows how to play the game. They have been stock buyers in the last couple weeks of a quarter for years whenever they needed to reduce outstanding shares so they could hit earnings estimates. Earnings divided by shares equals earnings per share. Lower shares outstanding and the earnings per share rises. That brings up another question. Could IBM be facing an earnings problem that will require a larger than normal late quarter buyback to bring them in under the wire when earnings are reported in July?

Takeover speculation is rampant with several announcements made every day. Micron (MU) spiked +4% on Friday on rumors they were going to be bought. With a PE of 46 they are not cheap and with constant worries about falling chip prices why would anybody bother to buy them? Navteq (NVT) is rumored to be a target by Google, which uses NVT for their various mapping products. Trimble Navigation (TRMB) is also speculated as a target along with numerous biotech companies ahead of the ASCO conference next week. With a dozen buyouts announced each week and few companies too big to be immune the fear of being out of the market when merger Monday arrives is a powerful motivator. Even American Idol, the most popular show on TV was not immune. CKX Inc (CKXE) the owner of American Idol, the Elvis and Mohammed Ali brands and several lesser-known assets spiked +38% on Friday after the board accepted a $1.33 billion buyout offer from the CEO Robert Sullivan. One investor group was quick to sue saying the 29% premium was vastly too low given the value of those brands. Just last January Silverman was listing the benefits to keeping it a public company. Now Silverman claims he needs to take it private in order to raise capital to invest in "real estate and location based attractions" for the names it owns. I thought you went public so you could raise capital? Silverman's group owns some land in Vegas and the rights to build an Elvis themed hotel/casino called what else but the "Heartbreak Hotel."

Dell rose +.38 cents after posting better than expected earnings in a clear case of under promise and over deliver. The stock gains were actually due to their announcement of a 10% layoff and expected cost reductions from a new restructuring effort. Dell said their profit increase was due to a favorable decline in component prices. Several analysts cut their ratings saying the positive trends are unlikely to persist. Dell's results were unofficial since they have not filed an official report in the prior two quarters due to ongoing accounting probes. Dell did not give any estimates for the current quarter but warned that margins would be under pressure as business slowed due to seasonal factors.

Homebuilder Hovnanian (HOV) warned again late Thursday that subprime problems continued to plague new home sales with drops in new home sales and average selling prices. Most analysts expected the current spring selling season, the year's busiest, to revitalize the home sales market. Hovnanian joined the other builders confirming that has not yet happened. They said the market weakened even further as the quarter progressed. HOV withdrew its guidance for the rest of 2007 due to the downturn in outlook. Banc of America analyst Daniel Oppenheim said he expects HOV and others to continue to cut prices until they can find a level where buyers find value. CEO Hovnanian appeared on a TV show late Friday and said we (all the builders) thought we had seen the bottom in Q1 but the subprime problem killed the rebound. Now it appears Q2 will be the bottom but we will not know until later this year.

July Crude Futures Chart - Daily

Commodity stocks like oil, copper and steel led the charge higher on Friday for a variety of reasons. Various countries have recently reported higher than expected growth and that is squeezing already tight supplies of metals. There are rumored mergers involving nearly every major name in the sector so nobody wants to be left out if a major roll up occurs. Oil prices rebounded sharply after the week's inventory report showed a drop of 2 million barrels of crude and no material build in refined products like gasoline. Crude had declined on Thursday to $62.48 on cooling geopolitical tensions in Iran and Nigeria and the passing of the Memorial Day weekend. Typically oil prices rise into Memorial Day on expectations of a strong driving season and then weaken as the season actually arrives. BP said on Friday the restart of the Whiting Indiana refinery could be put off longer than expected and they declared force majeure on Canadian crude purchases. They are devoting what capacity they have available to gasoline from light sweet crude but that is a small stream in a very big pipe. The plant was supposed to be offline for 4-6 weeks but that has now stretched into months. They declined to give an estimate for a restart. The Whiting refinery is BP's largest in the U.S. and the 5th largest of any U.S. operator. Further complicating the gasoline problem is a leak in the main crude pipeline linking Canadian oil to Midwest refineries. The pipeline is owned by Enbridge. They discovered the leak in mid-April and cut daily throughput by 90,000 barrels. Enbridge is in the "final stages" of determining the cause of the leak and work should begin soon to repair it. That could impact earnings for Canadian suppliers unable to ship their oil to the U.S. for refining. Refinery utilization for the week remained at 91.1% and well below the 94% average for this period and the level needed to stay ahead of demand.

Higher prices have failed to materially dent gasoline demand with demand averaging 93,000 bpd (+1%) over the same period in 2006 while the average price per gallon is 25 cents higher at $3.14. The next big consumption weekend is the July 4th weekend and with the 4th falling on a Tuesday it will be a long weekend for most with plenty of driving. The gasoline demand table below shows the steady increase in prices over the first four weeks of the demand period. The gasoline demand chart shows the current demand over the prior year. We should expect continued high gas prices until refinery utilization can catch up with demand.

Gasoline Demand Chart

Gasoline Demand Table

Now that summer is officially here it brought with it the beginning of the hurricane season. June 1st is the official start date and right on schedule a new storm appeared in the Gulf. Tropical storm Barry with winds up to 60 mph appears headed for the west coast of Florida and will likely cross the state and head up the eastern seaboard towards New York. Currently the track is well away from oil patch but the appearance of a sudden storm in the Gulf is a warning that others are coming. The National Weather Service reiterated their prediction of 7-10 hurricanes with 3-5 storms of category 3 intensity or above.

Remember the Russell 1000, 2000 and 3000 indexes will face their annual rebalancing on the last Friday in June. Russell will select the 3000 largest stocks in the U.S. and name them to the Russell 3000 index. The largest 1000 will become the Russell 1000 large cap index and the bottom 2000 will become the new Russell 2000 small cap index. The additions and deletions will be announced about a week before the rebalancing to give funds time to plan their proration strategy. When Friday June 29th arrives it will likely be one of the heaviest trading days of the year as funds change weightings on 3000 stocks. The change in shares owned for stocks remaining in the index is minimal but remember there are 3000 stocks to adjust if the fund wants to index to exactly the Russell index weightings.

The markets are officially in breakout mode and various analysts are starting to pull numbers out of their head like Dow 16000 and S&P 1725 by year end. With all the liquidity chasing stocks it could easily happen simply because there are an equal number predicting an earth shaking crash. As I reported earlier the short interest on the NYSE remains at an all time high and represents more than 3.1% of all outstanding shares. That is a huge bearish bet that the bulls are winning on a daily basis. Because bears and bulls are both stubborn when it comes to changing their coats the bears continue to stupidly re-short at every sign of weakness. The bulls pile into every dip as though it was the last chance to buy before Dow 16000. The bears are forced to cover and the scenario repeats.

Those waiting for a correction dip to buy have ended up chasing prices higher and higher and higher. The markets have overcome earnings worries, recession worries, Fed worries, housing worries, geopolitical concerns, high oil prices and the list just keeps growing. Bull markets need adversity to keep moving. It is said that bull markets do best when climbing a wall of worry. That has surely been the case over the last few months. The worry factors lure the bears into their short positions and a day later the bulls stampede over them. I must have heard 20 analysts on CNBC over the last two days cautioning about the coming correction. This is great news for the bulls because it gives the bears another glimmer of hope to keep the process functioning.

The markets have been moving higher for the last nine weeks. Not all at the same time or the same pace. Over the last three weeks the Nasdaq and Russell lagged the Dow and S&P and appeared to be weakening. It was a clever post earnings trap and the bears fell into it. We had two China events with Greenspan warning about a crash and several days later China raised the stamp tax on trading. Both events caused sharp drops led by the Chinese markets but the dips were bought on a global scale. I lost count this week on how many exchanges around the world were at multi year if not historic highs. It is that liquidity wave everybody is surfing and it is worldwide. All waves of any type eventually crash onto shore and disappear but there is no land in sight today.

When markets truly go into breakout mode it is a powerful sight to watch. Here in the U.S. the Dow Transports broke out of strong overhead resistance on Thursday to a new high at the same time the Dow Industrials were hitting new highs over 13600. For long time market watchers the dual action is a powerful confirmation signal. The breakout twins were quickly joined by the Nasdaq Composite, NDX, Russell 1000 and 2000, SPX, OEX, and the Wilshire 5000 to name a few. The respective breakouts over their prior resistance highs triggered broad based short covering as well as new buying by those keeping cash on the sidelines until the breakout appeared.

Friday's market wandered intraday but the final direction was never in doubt. Advances were 2:1 over decliners and for a post holiday, summer Friday, volume was decent at 5.2 billion shares. When the breakout began on Thursday the internals were just as strong and volume was well over 6.1 billion shares.

After spending three days in the dumps the Dow managed to sprint higher to close at 13668 for a +161 weekly gain. The Dow has posted gains for 8 of the last 9 weeks. The projected target generated by the last dip to 12000 was 13600 and that has been hit. (12800 high + (12800 high - 12000 low)) = 13600. There is no material resistance ahead for the Dow and no reason for it to decline other than being severely overbought. At least no outside reason we can see today. The event that will eventually kill the rally will be one that comes out of the blue completely unexpected. Until then, buy the dips.

The Nasdaq is the perennial laggard here and would have to add another 2500 points to reach its 2000 high at 5132. However, it has finally broken out again to a new six-year high and techs are coming back into favor. Unlike the other indexes at new historic highs the Nasdaq has chartable resistance at 2650, which is a 38% retracement from the 2000 high at 5132 to the 2002 low at 1108. Look at the Nasdaq chart at the beginning of this commentary and notice the long legged doji candle from Friday. This represents strong indecision and typically indicates a direction change. I am sure the bulls have other plans but based strictly on the doji I would be a little more cautious on Monday.

The SPX finally broke through the 2000 closing high at 1527 but has failed to match the 1552 intraday high from that same period. With targets being mentioned from 1600 to 1725 it would seem there are only blue skies ahead but the S&P has been moving even slower than the Nasdaq. At this point slow is good. It implies calm rational buying as opposed to irrational exuberance. With uptrend resistance at 1545-1550 it still has room to run. In the last month the S&P dipped five times or roughly every five days. 1510 is decent support but it would take more than just a normal dip to hit it. Something in the 1520 range would be a dip to buy.

SPX Chart - Daily

NYSE Composite Chart - Daily

Russell-2000 Chart - Daily

The Russell 2000 recovered from its six-weeks of consolidation and broke over resistance at 835 to move the fund manager sentiment indicator back to bullish. With Friday's close at 853 the next material resistance is around 875. With all the indexes breaking out on Friday I was surprised not to hear any reporters talking about the NYSE Composite. The NYA closed over 10,000 for the first time ever at 10040 and very near the highs for the day. This is further confirmation of the increasingly bullish sentiment spreading through the market. I know that seems strange since the Dow rally has lasted for weeks but the sentiment has been lagging until this week. The dual breakouts by the Russell and NYSE are even stronger confirmation of market sentiment for me than the combination of the Dow and the Transports. Having all four in breakout mode is very bullish. We just need to be aware that lightning can strike at any moment. Enjoy the picnic but keep your umbrella handy.

Economic Calendar

For next week the economic calendar is mostly filler with the major reports coming up on the following week. Tuesday's ISM Services is the only major report for the week but after last week's manufacturing ISM it may be anticlimactic.

This is also the week before option expiration week and recently we have seen additional volatility as the week draws to a close. Funds rarely hold options until the last minute and lately it appears they tend to roll forward or exit around Thursday a week ahead of expiration. We saw some big swings in recent months leaving expiration week to be somewhat boring. Ignoring any option cycle gyrations I would continue to buy the dips until conditions change.

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