Option Investor
Market Wrap

Strike Two

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For two consecutive days the major averages have tried to rebound but have failed at initial resistance. The bulls can't seem to maintain traction but the bears are struggling to gain momentum as well. It appears we are in a holding pattern while we wait for the PPI and CPI later this week. Negative news from the housing sector continues to weigh on the market but that same news is keeping the Fed on the sidelines. The mixed messages are keeping volatility high as we head into option expiration this Friday.

Dow Chart - Daily

Nasdaq Chart - Daily

The economic reports for today were just filler as we await for the PPI/CPI on Thr/Fri. Today's Chain store sales snapshot for the week saw a rise in sales of +1% compared to the prior week's -0.5% decline. These numbers never vary much and the report is mostly ignored. The Treasury budget came in at -$67.7 billion and right inline with estimates. Yawn.

The Job Openings and Labor Turnover Survey (JOLTS) showed that 4.79 million workers were hired in April while 4.58 million left their jobs for a variety of reasons. Openings decreased to 4.14 million from 4.18 million. The hire rate remained the same at 3.5%. This was also a report that traders ignore unless there was a surprise change in statistics with a major imbalance of hires over quits. This report tells us the strength in the labor market may be easing but there is no weakness. Hires and quits are roughly equal and there is no employment shift in progress. With employment stable it continues to suggest the economy is not in danger of a material decline into a recession. All indicators continue to point to a growing economy and a Fed on hold.


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The big economic news for the day did not come from the government. RealtyTrac reported the foreclosure rates for May and they were extremely bearish. Total filings were up +19% from April's already high levels. There were 176,137 foreclosure actions in May. Since May is typically one of the biggest home buying months it indicates an even weaker market than most had thought. More than 50% of all home sales occur from April through June. The average home price fell -1.8% nationwide in May and this continued decline is making it tough for homeowners in trouble to liquidate their properties to avoid foreclosure. California posted the largest increase with a +30% jump over April and a +305% increase over the same period in 2006. Nevada had the highest rate with one filing for every 166 households and five times the May 2006 rate. Colorado was second with one for every 290 households. This compares to states like New Jersey (15th) at 1 for 843 households and New York (30th) with one for 1,818 households. Countrywide Financial reported twice the number of foreclosures over 2006.

The foreclosure rate is expected to increase later this year. When the new mortgage rules take effect in September it will remove even more buyers from the market. Following that hurdle the more than $1 trillion in 2/28 mortgages written in Q4-2005 will reset at interest rates nearly double where they started. A 2/28 loan is sometimes called a band-aid loan and is offered to people with weak credit. The first 2 years are fixed with a very low rate but the last 28 years float with normally high adjustments off the LIBOR index rate. The concept is to give people with credit problems 2 years to clean up their act and hopefully qualify for a better rate when they refinance at the end of 2 years. Very few people actually qualify for a better rate after the initial 2 years and when the 3rd year adjustable rate kicks in the problem only gets worse. The resets will come in Q4-07 and Q1-08 and are expected to produce another even stronger wave of foreclosures as these weak borrowers are flushed out but that is expected to be the end of the mortgage blues and the potential bottom in the housing market. We are already seeing a rebound here in Colorado with the number of homes for sale decreasing and the average number of days on the market falling. This is probably due to the normal April-June buying spree rather than a change in housing trends. Countrywide reported a +15% jump in mortgages applications in May. Essential payments for things like food, energy, rent/mortgage payments now averages more than 55% of grow income for U.S. consumers. That is an all time high and leaves very little discretionary income after taxes, insurance and credit card bills. This is yet another reason why buyers are not rushing back into the housing market. According to Bankrate.com, the average 30-year fixed-rate mortgage for prime borrowers spiked to 6.33 percent on Tuesday, up from 6.07 percent a week ago.

Bond rates spiked again hitting a five-year high of 5.303% on the ten-year note. The last time rates were this high was April 2nd 2002 at 5.27%. Everything appears to be weighing on bonds and nobody is buying the bond dip. The ten-year note auction did not go well this week and traders expect prices to drop even further when those winning dealers begin reselling those notes into the market. There is a growing feeling that Asian buyers who have provided a strong support base for bonds are losing their appetite for dollar denominated debt. Greenspan spoke today and said he was not concerned there would be wholesale dumping of treasuries by China. He said they would be unlikely to dump their dollar debt since they would have trouble finding buyers for that much debt and that would force prices even lower. That was not encouraging for bond traders who immediately hit the sell button again pushing the yields to the new 5-year high. Unfortunately we know from reports from Chicago that Asian accounts have been selling all manner of dollar denominated debt for about the last five weeks. Apparently Greenspan has not been keeping up with the news. He also warned that the current Chinese growth rate could not continue and that P/E ratios on China stocks were "discounting nirvana."

I disagree with Greenspan's China view in the short term. I read an interesting article last week written by David DuByne, a resident of Chongqing, a city of 30 million people in central China. (http://www.energybulletin.net/30384.html) China is pushing its "Go West" campaign to convince people wanting to move to the cities to consider moving westward instead of the overcrowded eastern areas. Every road in the nation is being upgraded to concrete to allow faster movement of people and goods. China currently consumes 45% of the world's cement supplies each year and that is expected to grow by 8.5% in 2007. New rail lines are being built parallel to existing lines to add more capacity for goods and people. 15,000 kilometers of existing routes are being upgraded and 19,800 kilometers of new tracks are being added before 2010. They are damming two major rivers with a series of 21 dams to produce more than 120 million megawatts of electricity to power another generation of factories now in the planning stages. China is funding loans for university educations for anyone willing to work in the western part of the country for at least three years upon graduation. They even offer job placement and the loans are forgiven at the end of the three years. Autos are increasing exponentially with 3,000 being added in the city of Chongqing every day. Multiply that across all of China and it is not surprising their oil consumption is now expected to rise by 20% per year. I used to agree with analysts saying China's growth would slow once the Olympic preparations have passed but I have changed my opinion. I believe it will continue until at least 2015 and maybe even longer. I would buy any material dip in the major Chinese equities listed on the U.S. exchanges.

Greenspan also warned that rates on various types of debt would continue to rise as "affluence spreads throughout what we used to call the third world." He also saw higher rates on treasuries as well. The Fed Fund Futures spiked on the comments to a 44% chance of a rate hike in the U.S. before year-end and zero percent chance of a rate cut by year-end. Rates on the ten-year notes hit their highs on his comments and the equities market began a new plunge to the lows of the day. Ironically equities had rallied back from a triple digit Dow loss to positive territory ahead of his comments but that rally was short lived as bonds were sold hard. The correlation between equities and bonds was very evident as seen in the chart below. As yields rose stocks plunged.

Comparison Chart - Ten Year Yield to SPX

Ten-Year Yield Chart - Monthly

The yield chart above shows major resistance at just below 5.5% and that should slow the selling. Selling in bonds causes yields to rise. If we are really seeing a change in global diversification of debt as was reported on Monday then this 5.5% level could only be a pause point before moving higher. Bill Gross said last week he could see rates as high as 6.5%. The massive holdings of our debt by foreign countries has been a topic of concern for more than a decade but like Greenspan commented today nobody ever expected a major shift away from that model since it was in their best interest to own US debt. Apparently that model has changed and greater diversification is the new plan. This could pressure our markets for quite some time.

Texas Instruments narrowed their guidance last night to 40-44 cents per share from 39-45 cents and reduced their revenue guidance to $3.44 billion and below the prior midpoint of $3.46 billion. The slight shrinkage in estimates was not material but it was enough to cause the entire sector to decline.

Lehman (LEH) reported earnings that rose +27% for the quarter on robust trading profits and fees from mergers and acquisitions. The gains helped offset sagging performance in its mortgage backed securities business. That division had been hurt by the subprime loan problem. CFO Chris O'Meara said "that is the beauty of having a diversified business" and "We continue to be optimistic about the future." Earnings of $2.21 per share were well over the $1.88 expected by analysts. This bodes well for Goldman Sachs, which reports earnings on Thursday.

The major indexes rallied back from an early morning triple digit loss on the Dow at -105 to a +25 gain at 2:PM. The indexes then plunged on the Greenspan comments and on news that Iran was supplying IEDs (Improvised Explosive Devices) to the Taliban in Afghanistan. The rebound from the opening drop was technically bullish as a rebound from a higher low and all we needed was a move over the prior days high to produce confirmation that the worst was over. Unfortunately the afternoon drop erased that potentially bullish view and put the bulls in the position of hoping for a Wednesday rebound from Friday's lows that they could claim as a successful retest and a another reason to buy.

The afternoon drop was blamed on several different factors as I reported above. I believe they were useful as excuses and probably had some impact but that afternoon failure occurred exactly at clear resistance. If the decline was simply news related it would not have occurred at a specific resistance point. As long time readers may remember I use two specific averages for market direction and they have been nearly flawless in the recent market action. I use the 100 and 130 period exponential averages (High/Low) on the 30 min chart. These averages work best with the Dow and S&P and this week's action depicted below is a textbook reaction. The afternoon touch of the 100-period produced an instant reaction as sell programs were triggered.

Dow & SPX Resistance Charts

Current support on the Dow is 13250 and unless sentiment changes by tomorrow the odds are good it will be tested again. The S&P has support at 1490 and that is only three points below our close.

The Nasdaq has initial support at 2550 and again at several points between 2540 and 2500. About every 5 points can claim to be a support point given the fitful advance in early May. Without any material event the Nasdaq should be able to weather the storm on Wednesday.

The most bearish chart is the Dow Transports, which have declined from a new high at 5347 on June 1st to close at a two month low of 4995 today. The falling transports can't be blamed on oil prices because prices were higher in prior weeks when the transports were in rally mode. With the Dow transports far weaker than the Dow Industrials the damage to market sentiment is growing.

Dow Transports Chart - Daily

Russell 2000 Chart

The Russell-2000 was also weaker than the other major indexes and I believe that is related both to Tuesday's news but also to the rebalance announced on Monday. The reconstitution announcement listed 277 new companies moving into the Russell index and about the same number being removed. Historically those being added will rise into the June 22nd balance date while those being removed will decline ahead of that date as funds and traders try to improve performance by gaming the index change. Since the deletions, still in the index until 6/22, are sold they tend to drag down the index ahead of the date. This drag can be minimal in a bull market but can add significant volume in a down market. The additions, which will have no impact on the index value until 6/23, will perform better than the general market over the next two weeks but won't help the index.

For Russell additions, click here.
For Russell deletions, click here.

Given the number of negative news factors I am having a tough time coming up with a bullish scenario for the rest of the week. I would love for the market to find traction and roar off to new highs but I have found that hoping for a rally never seems to work. The key focus points for the rest of the week are the Beige Book on Wednesday, Producer Price Index (PPI) on Thursday and Consumer Price Index (CPI) on Friday. Either of the price indexes could produce strong reaction moves in either direction depending on the outcome. If the inflation components show a sharp spike it would accelerate Fed fears and chances of a rate hike. If there was a dramatic slowing in the inflation components we could get an equal reaction to the upside on hopes the Fed tensions would cool. The most likely outcome is a neutral report leaving the indexes to wander aimlessly into Friday's option expiration. This would be a good week to watch from the sidelines or take some short-term trades on the Russell rebalance.

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