Option Investor
Market Wrap

Falling Rain

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They say in every life a little rain must fall. That is also true for bull markets. Today's dip was just a passing cloud without the added excitement of lightning and thunder. Without rain it is impossible for flowers to grow and the same is true for stocks. Without a weekly buying opportunity buyers will just wait on the sidelines rather than buy the top. When the rain clouds come those buyers emerge to frolic in the rain like Gene Kelly in his famous dance routine. Those smiles from being given another buying opportunity could quickly turn to frowns if the rain turns into a flood but there are no signs of increasing precipitation today.

Dow Chart - 120 min

Nasdaq Chart - Daily

The lone clap of thunder to start our drizzly day came when the ISM Services report blew in with a headline number of 59.7 compared to estimates of only 56. This upside surprise boosted the index to levels of activity not seen since April-2006. The services index rebounded much more sharply than the manufacturing index released on Friday. That index rose only .3 points to 55.0. Today's +3.7 point spike in services indicates the economy may be rebounding much stronger than previously expected. Since the U.S. has been moving to more of a services based economy rather than increasing its manufacturing base we should see the services index rebound more quickly. This was the second consecutive month of strong gains with a jump in April to 56.0 from 52.4. March was the low point for this cycle at 52.4. The employment component rose to 54.9 from its March low at 50.8 indicating an increase in hiring and hiring means owners are optimistic about the future. Unfortunately the prices paid component rose to its cycle high at 66.4 showing that inflationary pressure are increasing at least in the services sector. This could be directly related to the price of gasoline given the record levels seen in May. Only 4% of companies surveyed reported seeing lower prices. New orders rose to 57.4 but order backlogs fell into contraction territory at 48.0. This was the second consecutive month of declines in backlogs. The biggest boost of all came from new export orders, which spiked +10.5 points to 66.0. Inventories also spiked +9 points to 61.0 suggesting companies are stocking up for what they hope will be a strong summer season.

The ISM Services report was the only major economic indicator this morning but it was enough. The markets plunged on the ISM news and on expectations that the next Fed move will be a rate hike. You know how many times expectations for cuts/hikes have changed in the last year. I feel like a metronome just in reporting it. Hike, cut, hike, cut, on and on for a year now. After today's news the odds of another reversion back to a rate cut scenario is highly unlikely for the rest of the year. The stronger than expected economy, moderating inflation as seen in the PCE deflator and treasury yields at 5% should keep the Fed on hold for the rest of the year. However, analysts are now leaning even stronger toward the possibility of rate hikes before year-end. Everything is pointing towards a strong GDP of as much as 3.0% for Q2 and even higher for the rest of the year. How quickly we are moving right back into strong growth mode and that tends to fuel inflation. That brought the inflation bears out to play in today's market but the bulls have not given up. They claim having the Fed on hold until late in the year is a good thing and even if there are a couple more hikes it would only be due to a strong economy and that is good for stocks. Obviously this topic will continue to be discussed for months to come.

Bernanke spoke on Tuesday in what could have been termed another economic report. Bernanke stressed that his primary concern is inflation now that the economy is on the road to recovery. He said, "On average, over coming quarters, we expect the economy to advance at a moderate pace, close to or slightly below the economy's trend rate of expansion." That would be about 3% growth according to economists. He said some of the factors that slowed the economy in Q1 "seem likely to be at least partially reversed in the near term." He also said the downturn in housing is still ongoing and the drag from that sector may last "for somewhat longer than previously expected. Thus far, however, we have not seen major spillovers from housing onto other sectors of the economy." His comments on inflation helped pound the nails into the rate cut coffin and prompted further selling in treasuries. The yield on the ten-year note rose to 4.99% intraday high and a level not seen since August 2006. Rates at 5% or above are typically negative for equity markets.


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Tomorrow's reports include Mortgage Applications, Challenger Employment Report, Productivity and Costs and Oil and Gas Inventories. None are expected to be market movers.

It was a very quiet day in the markets despite the triple digit intraday drop. The merger and acquisition train steamed right along losing no speed. Silver Lake and TPG Capital partnered to buy Avaya (AV) for $8.2 billion. Avaya was sitting on $829 million in cash and no debt. Despite that cash hoard and sales of $5.15 billion in 2006 they posted a net profit of only $200 million for the entire year. That would not be my choice for an $8.2 billion investment but maybe they see the opportunity for a large improvement. Avaya executives said they would be able to move faster to improve the company if they don't have to worry about meeting the short-term concerns of public investors. Avaya's main competitors are Cisco, Nortel and Siemens. That is a tough group to fight. Israeli communications company Alvarion (ALVR) spiked +7% on 13 times normal option volume after the Avaya deal was announced. Evidently somebody thinks ALVR will be a takeout as well.

Apple Inc rose slightly to $122 and change after announcing the release date for the iPhone and being upgraded by Credit Suisse and Morgan Stanley. Credit Suisse raised their price target to $140 from $120 and Morgan raised their target to $150. I took profits at $118 last week so I am watching those gains from the sidelines.

Google closed at a new historic high at $518.95 after an agreement with SalesForce.com (CRM) was announced. SalesForce will put out a new version of its software so its 32,300 customers can distribute their online ads through Google. Some analysts speculated that a successful integration would make SalesForce an acquisition target very quickly. Google also announced they were buying PeakStream Inc, a startup that sells programming tools for high speed computer chips with multiple processors. Google will also start brokering radio ads on its website on Wednesday.

Amazon (AMZN) saw its shares rise to a seven year high on news they were going to increase their investment in China. A +5% gain to $73.65 took Amazon to a post-bust high and their PE nearly to triple digits. The Chinese Internet site Joyo.com was bought by Amazon in 2004. Amazon shorts have been getting crushed after the late April breakout. On April 13th there 48 million shares short or roughly 10.1 days to cover according to the Nasdaq. That total rose to 54 million shares on May-15th. Average daily volume was around 6 million shares until the news squeeze began on April 16th. Today Amazon traded over 30 million shares and I heard two analysts recommending it as a short at this level. For a company that has been written off as a pending failure for years and dead money for the last three it appears Jeff Bezos has returned to rock star status.

Amazon Chart - Weekly

CROX jumped +2.88 after debuting a new line of shoes that are not made of their colorful trademark plastic. The new line was targeted at "fashion conscious" women. Retailing for $149-$299 are made from lamb's wool, leather and suede with only the soles made from resin.

Intel announced a new series of faster chipsets expected to jump off the shelves because of the new high performance capabilities. That includes PCI Express 2.0 slots, which doubles bandwith for graphics cards and various HD Video features including high definition audio for up to 7.1 surround sound theater systems. These chipsets would also interface with HDMI components to allow PC driven HD theater systems. Investors were not impressed and Intel closed near its lows for the month.

Oil prices held their gains to close near $66 as we await inventory levels tomorrow and the impact of Cyclone Gonu in the Persian Gulf. Gonu was headed for the Oman coast with 120 mph winds as it traversed the Indian Ocean and headed towards the Straits of Hormuz. It was classed as a the first ever category 5 cyclone for that region but it weakened slightly on Tuesday to a category 4. A large portion of the world's oil (20mbpd) is shipped through a mile wide lane through the shallow straits. The arrival of the cyclone could delay tanker entry and exits from the Persian Gulf for 3-5 days and that could drive up oil prices. If Gonu does any damage to any of the oil fields surrounding the gulf we could see oil go a lot higher very quickly.

Cyclone Gonu

You can't listen to 30 min of any investment channel without hearing several mentions of China in a dozen different contexts. Lately it has been on fears that a collapse in their markets would lead to a global meltdown. On Monday the Shanghai Composite fell -8%. On Tuesday it opened with another -7.3% drop but investor rushed into the combined -15% dip to send it soaring +2.6% higher by days end. With a -15% dip you could have expected the U.S. markets to implode as we saw back in February when it happened the first time. I am sure a prolonged drop in China would have some impact on the U.S. but with their index up over 50% for the year everyone knows there is plenty of room for volatility without any serious ramifications. With Chinese brokerage accounts being opened at the rate of 300,000 per day, yes, no misprint, 300,000 per day, there will be plenty of new money flowing into every dip. With 300,000 newbie investors with no investing skills hitting the market every day the end result is eventually going to be ugly. Remember the Nasdaq in 2000 was fueled mostly by new investors with no skills. Most of them blew all their gains and their initial investments when the bust came and that is likely to happen in China as well. But, that is a story for a future newsletter.

For a -123 point intraday drop you would have expected a little panic or maybe some stops getting hit. Instead the major indexes slipped gently back to support and buyers started drifting back in at the close. There was no rush to buy the dip and that could be the subtle difference indicating a change in the wind. Buyers were there and willing to buy support but nobody was chasing prices higher. Volume was heavy at 5.6 billion shares and as you would expect lopsided with a 5:2 advantage going to the sellers. Still, there were no signs of an impending disaster. Since equity disasters rarely telegraph their presence I would not hang my hat on a lackluster sell off as bullish news. We are currently in the longest period since 1926 without a correction and the bears like to keep reminding us of that statistic. The ISM simply provided the bulls with an excuse to take profits and let the bears reload their shorts.

The Dow declined from its 13690 high on Monday to support at 13550 intraday. That flurry of buyers returning at the close managed to add +40 points to close just under 13600. The Dow has a lot of support at 13500 and we could easily have another triple digit day to the downside without causing any harm to the rally.

The Nasdaq declined to just below 2600 and a level that is turning into pretty decent support. Tech stocks rebounded quicker and with greater volume to lift the Nasdaq +15 points from its intraday low. After six days of gains it was time for the Nasdaq to rest and I don't consider a -7 point day anything but noise. 2620 is currently near term resistance. We could decline to strong support at 2540 without a material impact.

NYSE Composite Chart - Daily

S&P-500 Chart - 120 min

The S&P fell back to 1530 and I fear that number will continue returning to haunt us. It was a challenge as resistance back in mid May and I am hoping that resistance turns into support but we spent most of Tuesday below that level only to sneak higher at the close. The S&P has support at 1520 and again at 1510 and 1500. There are plenty of levels to regroup if the bears mount a concentrated attack.

As the week before option expiration I expect at least one day with a major move this week. Funds have been exiting expiring options earlier each cycle but I don't think today was it. There are no material economic reports the remainder of the week and we will be at the mercy of buyouts, buybacks and news events. Thomson Financial reported today that share buybacks hit a record $110.5 billion in Q1 and announced buybacks were already over $80 billion in Q2 and on pace to set a new record. As I discussed before this is removing available stock from the market at a historic pace. Add in the rapid pace of buyouts at around $100 billion a month and you have a lot of support under the market. These corporations buying back stock will have their buy orders in just under the bid to provide support but not be accused of pushing prices higher. This underlying bid should keep us from any major disasters but we can't count on it and overly extend our purchases. With margin loans at a record level any sharp drop could begin tagging those stops and take on a life of its own. Until we see evidence of a sentiment change in the market I would continue to buy the dip.

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