Option Investor
Market Wrap

Never A Dull Moment

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Whoever coined that phrase did not trade stocks. They say war consists of weeks of boredom interspersed by hours of sheer terror. That pretty much explains our markets this week. Days of boredom interspersed by five hours of major movement. The majority of activity was very low volatility sideways movement punctuated by two major sell programs and three major short squeezes. The result was a return from six-week lows to within a handful of points from the historic highs. All the worry about interest rates has evaporated with the tame inflation numbers and the bears were banished back to their caves at least temporarily.

Dow Chart - Daily

S&P-500 Chart - Daily

This was a major week for economic reports and Friday's CPI was the exclamation point for the week. Friday's Consumer Price Index (CPI) showed a headline jump in prices of +0.7% and slightly over consensus estimates. However the more important core rate increased a lower than expected +0.1% suggesting inflation was continuing to moderate bringing the trailing 12-month inflation rate down to +2.3%. The core rate calculation is coming under increasing fire as irrelevant since ignoring sharp price increases in food and energy is equivalent to sticking your head in the sand. Even the politicians are starting to take notice and question this practice.

The implied 2.3% CPI inflation rate for May was well below the 4.3% rate seen in June 2006. This decline has come despite the continuing sharp rise in energy related costs. Energy prices surged +5.3% in May producing an annualized rate for the trailing three-month spike to a whopping 70.9% if this rate continued. With ethanol production adding to the price of nearly every product made with corn and the current drought in the south east causing serious price hikes in wheat prices and those products made from wheat the prospect of a continued rise in food prices is very strong. Oil prices closed over $68 on Friday and that is without any hurricanes to fuel the spike. Officially inflation may be slowing but for those of us that use food and energy the prices are continuing to rise. Fortunately the markets are only concerned with the official numbers and their impact on the Fed. Friday's CPI report confirmed Thursday's PPI and suggests the Fed will be on hold for the rest of the year. That is good news for stocks.


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It appears the economy is rebounding strongly from the Q1 dip and that was evidenced in the NY Empire State Manufacturing Survey on Friday. The headline number soared to 25.8 from last months 8.0. Consensus estimates were for a slight gain to only 10.5. This is the third consecutive monthly increase from the low of 1.9 seen back in March. New orders rose to 17.2 from 8.0 and shipments to 29.8 from 14.1. The only components still weak were a drop in employment from 9.7 to 3.4 and a sharp drop in the average workweek to 3.2 from 11.1 and backorders remained flat. This would suggest an excess in capacity that has yet to be met with new orders. The availability of excess capacity will continue to prevent inflation in prices. It is when plants are running at full capacity with backorders building that prices rise at an inflationary rate. The price components bear this out. Prices paid rose +8 points but prices received fell -6 points. This imbalance suggests producers are eating the difference to keep orders flowing.

Another confirming indicator was a slow down in industrial production to a zero increase for May compared to a +0.4% increase in April and estimates of a +0.2% gain. Capacity utilization fell -0.2% to 81.3%. Production components were weak across all sectors but declines in auto production of -0.5% helped pull down the headline number. Capacity utilization fell to only 81.3% in May indicating a lot of slack capacity to keep prices in check.

Consumer Sentiment resumed its slide with a sharp drop to 83.7 in the initial June reading. This is down sharply from a reading of 88.3 in May. The decline was equally evident in both components. Present conditions fell to 100.2 from 105.1 and expectations fell to 73.0 from 77.6. The drop in the headline number took sentiment to the lowest level since last August. The drop in the stock market and continued high gas prices during the summer vacation season were given as the probable cause although the closing refinance window was also a drag.

Consumer Sentiment Chart

This was a heavy week for important economics but next week returns with a very light calendar. The only report of note for next week is the Philly Fed Survey on Thursday. The new residential construction report on Tuesday would come in second in importance. Stocks will begin to focus on the two-day FOMC meeting the following week. The Fed is expected to remain on hold and continue saying the economy is growing and inflation is moderating. That should remain their mantra for the rest of the year. The problem now could be faster than expected growth rekindling inflation fears. Q2 GDP estimates are now starting to hit 4% and that is in the range where the Fed will come back off the sidelines to slow growth again. Goldilocks may have had a brief return as the analogy of choice for economic growth that was just right and be headed back into obscurity very quickly. Over 4% GDP will bring a complete set of new problems with the chance for an inflation spike the biggest fear.

Economic Calendar

The bond crash may appear to be over but some feel the gains of the last two days were just an oversold bounce. The problem remains a shift in buying habits by Asian investors and the surging stock market. We had new numbers released on Friday and it appears foreign treasury buyers only bought $376 million in treasuries in April compared to $30.5 billion in March. Yes, millions compared to billions. This extremely sharp drop in buying continued in May according to anecdotal reports from traders who deal with Asian accounts. In the same period foreign investment into equities rose to $76.5 billion in April from only $39.9 billion in March. China reportedly sold $6 billion in treasuries last week but that leaves them with nearly $414 billion in inventory. The selling in bonds may have paused but any continued buying strike from foreign investors will pressure prices because our need to sell debt has not disappeared. Total foreign holdings of Treasury bills, notes and bonds stood at $2.166 trillion at the end of April.

In stock news Intel continued its dramatic rally of more than +10%, which started on June 8th. Intel added +4.3% on Friday alone. The newly found popularity came on several analyst upgrades and a strong menu of new products coming to market in the near future. Intel is expected to cut prices by 50% on its top-end Core 2 Duo chips and that will hurt margins but increase sales. AMD remains in the house of pain as Intel continues to stretch its performance lead. In Q1 Intel increased its global market share by +4.5% to 80.2% but Intel margins fell to 19% from the historic range of more than 30%. The shrinking margins come from its war with AMD and its plan on maintaining the processor lead for years to come. AMD surprised Intel a couple years ago with a dramatic leap forward in chip performance and caught Intel sleeping. Intel paid the price in lost market share and margins as it raced to catch up. Now that Intel is back in the lead on chip performance I doubt AMD will be able to claim any major share gains for years to come. AMD reported a loss of 90 cents per share in Q1 and warned not once but twice during the quarter. AMD is expected to release its four-processor chip, the Barcelona, later this summer but Intel is way ahead on that architecture. Intel is expected to announce an eight-processor chip later this year to leapfrog AMD once again. With Intel cutting prices so steeply it cuts AMD's profits to the bone and deprives them of capital for new projects and advertising. I would be a seller of AMD on any Barcelona bounce.

Penn National Gaming (PENN) agreed to be acquired by Fortress (FIG) and Centerbridge Partners for $8.9 billion in cash and debt assumption. That equates to $67 per share and PENN spiked +11 points (+21%) to $62.12 on the news. JP Morgan said they expected the eventual price to rise to as much as $80 per share as other buyers made higher offers. PENN has the right to solicit other offers for 45 days following the announcement. With casino stocks very hot the odds are good other bidders will appear. The acquisition is expected to close in about 12 months. If not the price increases by $0.0149 per share per day, which equates to another $1 in price every 67 days. I thought the chance of a higher offer was so good I picked up some Oct $65 calls just in case a bidding war erupts. The two giants in the field MGM ($24B) and HET ($16B) are the current targets of buyouts so well managed $9B PENN could easily see other bidders appear. Isle of Capri (ISLE), Pinnacle Entertainment (PNK) and Boyd Gaming (BYD) also rose on the possibility they could become targets.

The New York Mercantile Exchange (NMX) spiked +2.32 to climax a four-day +$20 run on reports they were exploring a sale for $14.3 billion. Reportedly the Nymex has had discussions with the NYSE Euronext (NYX), Chicago Mercantile Exchange (CME) and the Paris and Deutsche Bourses. Late Friday the CME said it is not currently in discussions with the Nymex and was focused on completing its CBOT merger. This caused a loss of -$7 from the morning highs as expectations dimmed. Analysts feel a Nymex/CME merger would be the best fit although tough to handle from a regulator approval standpoint. A merger with the NYSE would create a powerhouse to compete with the combined CME/CBOT entity. For a cash exchange like the NYSE to acquire the Nymex would allow it to offer futures products from a proven platform to all its current customers. The race to find dance partners is heating up as the exchanges try to increase their global footprint before all the partners are gone. The Nasdaq currently owns 30% of the London Stock Exchange and the Deutsche Boerse in Frankfurt agreed to buy the International Securities Exchange (ISE) for $2.8 billion. It is only a matter of time before a deal with the Nymex is announced so I would be a buyer on any pullback.

Apple Inc. (AAPL) had a tough week with a dip into the $116 range after trading as high as $127.61 last Thursday. With the iPhone release scheduled for the end of June we are seeing analyst downgrades on price and expectations being fully priced. Reviewers are starting to complain about things they don't like about the phone and caution on bandwidth, battery life, keyboard problems, etc. All this and the phone is not even out in the public hands. This sets up a strong potential for a real sell the news event if the actual consumer product fails in any area or feature. With Apple near historic highs there is more risk to the downside than the upside on the release date. Analysts are starting to turn their attention to Nokia, which claims a significant share of the global handset market, and their new N95 phone. This will be a direct competitor to the iPhone and includes more features than I could list in this commentary. It is a cross between Blackberry and iPhone with a lot of Nokia features thrown in. Analysts claim hitching your wagon to the Nokia star before the N95 is officially announced with a carrier in the U.S. would be a wise move. With Nokia (NOK) at $29 those long-term options are a lot cheaper than AAPL. Research in Motion (RIMM), maker of the Blackberry, is also expected to get a strong boost by the delivery of the iPhone and the announcement of the N95 by Nokia. Both are very expensive relative to prior fully featured phones with the iPhone around $500 and the N95 at $700. That is prime Blackberry territory and some analysts believe a group of consumers will watch the ads and handle the products and then opt for the proven capabilities of the Blackberry product. Once you rationalize spending $600 for a phone your product shopping has to factor the Blackberry back into the picture. On the RIMM chart you will see RIMM began to rise when AAPL began to fall last week.

On Friday it was reported that China was supplying weapons and explosives to the Iraq insurgents and the Taliban. Weapons being delivered to these groups include HN-5 anti-aircraft missiles, large caliber rifles, millions of round of ammo, rocket-propelled grenades and components for roadside bombs. All are being used to step up the attacks on U.S. soldiers. This should create chill bumps on defense planners who already know that China is concealing nearly two-thirds of its military budget to prevent the world from realizing how rapidly they are modernizing and building their forces. Why China would want to take sides with the Taliban against the terrorist coalition headed by the U.S. is a serious question. On Friday the administration said it was tightening controls on a range of high-technology products eligible for export to China for fear they would end up in military applications. A pentagon official testified before Congress this week that China was spending as much as $125 billion on defense this year while reporting only $45 billion. He also testified China was making strides on anti satellite weapons that only have one major target and that is U.S. communication and spy satellites. Last month the Pentagon reported to Congress that China was modernizing its capability to mount surprise attacks potentially far from its borders. In a world where a Chinese official says at least once a month that war with the U.S. is inevitable and the U.S. is monitoring the preparations for a potential war I would not expect any material gains on the yuan devaluation problem, human rights, censorship or additional major purchases of U.S. debt. Maybe it is just me but hopefully the pentagon and stock market analysts are drawing the right conclusion. I don't view any confrontation any time soon but once the 2008 Olympics are behind us and China's economic revitalization program is completed I expect relations to become increasingly tense. China is continuing to acquire strategic assets around the world with miner BHP rumored to be an acquisition target to guarantee future metal supplies. Once peak oil officially arrives the shooting war will not be far behind.

Tensions around the world led by Iran's vow to never halt uranium enrichment and the problems in Israel sent oil prices to $68.05 and a nine-month high close on Friday. This spike was aided by a drop in refinery utilization and no increase in inventory levels of oil or gasoline in the weekly report. OPEC continues to claim no production adjustments will be made before the regular September meeting and we are now in hurricane season where a storm could be reported any day. This list of problems should keep a floor under crude for weeks to come. Gasoline prices continued to decline with a drop of -8 cents in the national average for regular gasoline. At $3.08 it is still nearly a buck over the futures price at $2.12 per gallon. On Wednesday oil and gasoline inventory levels were flat over the prior week in contrast to expectations for a decent build. What really pushed prices higher in the U.S. was the drop in refinery utilization to 89.2%, more than a full percent below estimates and at a time when utilization should be running around 94%. Refiners just can't seem to keep them running this year and this is without any hurricane problems that kept some offline for months in 2005. July crude futures terminate trading next Tuesday so expect further volatility as the contract month's change.

GGas Demand Chart

July Crude Futures - Daily

Wheat prices soared to a 10-year high this week as wet weather drowned crops on the plains and droughts killed crops in the south and other major production areas like the Black Sea region and Australia. With global supplies at a 30-year low and three of the six major producers hammered by weather problems we can expect wheat prices to continue to rise. This will impact the prices consumers pay for bread and any other product made with wheat. Wheat prices hit $6.11 a bushel on Thursday, +83 cents for the first four days of trading, and the first time over $6 since an Australian drought in 1996 sent prices to an all-time high of $7.50. This spike in both corn and wheat prices will pressure profits at cereal makers like Kellogg (K) and General Mills (GIS). Both have fallen sharply since the beginning of June despite 10% increases in cereal prices over the last year. Every time I buy cereal it appears the boxes got smaller and the price was higher.

December Wheat Futures Chart - Daily

December Corn Futures Chart - Weekly

The sharp increase in corn prices to create ethanol has pushed the price of milk to more than $4 per gallon in some areas and analysts expect it to top $5 before the year is out. Corn prices have risen +73% in the past year due to ethanol demand. Corn also hit a three-month high of $4.095 per bushel on Thursday after hitting a 10-year high of $4.5025 on Feb-26th. The government is subsidizing ethanol producers at a rate of 51 cents per gallon to stimulate production. This allows producers to pay more for corn and that pushes feed higher impacting both milk and beef prices. The USDA expects food prices to rise +4.5% in 2006 as a result of the corn and wheat price hikes. Don't worry though the government economists claim there is no inflation at the consumer level. Obviously they don't consume. The way to play the agriculture trend is with the fertilizer and tractor companies, Deere (DE), Monsanto (MON), Potash (POT) and Terra Nitrogen (TNH - No options).

Friday was a quadruple witching options expiration and a rebalance day for the S&P-500. This produced very strong volume and helped feed the short covering. The S&P is a capitalization weighted index and they rebalance every quarter for things like stock buybacks, which reduces the market cap of those companies. This was a particularly strong quarter for buybacks with companies like Microsoft buying back billions in stock. Actually $6.8 billion or nearly 2% of outstanding shares for Microsoft. Other companies taking stock off the market during the quarter include XOM $5.0B, T $3.1B, JPM $2.9B and WMT $2.1B. Remember this lowers their outstanding shares and increases the earnings per share making it more likely they will meet or beat the street estimates for Q2. Many times companies have this as an ulterior motive for a sudden large buyback program. Fund managers must sell shares in those companies to reduce their weighting as of Friday's close while at the same time buying shares of those companies moving up in the ranks. The quarterly rebalances on the S&P rarely impacts the market because the changes are so trivial and those few companies getting sold are being offset by those being bought. In theory it is a zero sum rebalance unlike the Russell rebalance next Friday.

The expiration activity pushed volume across all markets to 6.49 billion shares. I heard one analyst talking about the possible Nymex merger/acquisition saying we could see 10 billion share days by 2010. I doubt it will take that long given the number of ETFs being announced each week. Those are becoming the investment vehicles of choice and investors can move in and out of multiple baskets of stocks both domestic and foreign with a simple mouse click. Overall volume was weighted 3:1 advancers over decliners with about a 2:1 advantage of advancers to decliners in individual stocks. New 52-week highs hit 629 and a level not seen since June 1st.

The Dow rebounded to within 3 points of its all time intraday high of 13691 set back on June 1st. That high was attained on the morning short squeeze produced by the supposedly tame inflation in the CPI report. The Dow hit a low for the week at 13287 on Wednesday morning. Three reports, Beige Book, PPI and CPI, and three short squeezes later the Dow had added nearly +400 points from those Wednesday morning lows. That was only a 200-point gain for the week but still a nice performance. In the graphic below I highlighted the three squeezes that powered this move. Each was event related and took advantage of a heavily shorted market. Please note the absolutely lackluster periods that followed the opening squeeze on Thr/Fri. If this were a true buying binge on low inflation excitement it would have continued all day. The excitement faded just as quickly as it started and the return to the highs from two weeks ago did not produce any bullish confirmation signs.

Dow Short Squeeze Chart - 10 min

Nasdaq Chart - Daily

The Nasdaq gapped open +30 points to 2630 and then traded in a very narrow 5-point range for the rest of the day. The dead stop at long-term resistance created a Doji candle that could be the start of a new decline. Every candlestick formation that includes the doji requires the next candle to form a pattern. Most are reversals of some form.

Am I predicting a reversal, definitely not. I would rather just play what the market gives us on Monday. A failure here on the Dow would give the bears a nice opportunity to short a double top. Without any economic reports to feed the next squeeze we will be at the mercy of any buyout reports on Monday OR the lack of any buyouts. I simply feel the lack of any material intraday uptrend after the morning squeezes suggests there was no bullish conviction behind the spikes. It could also mean the bulls just did not want to buy the spike and would prefer to wait for another pullback once the expiration pressures evaporated. For next week we have a nearly perfect setup for the bears to short and give the bulls one more chance to trample them. There are no economics to cloud the issue and the Fed meeting on the 27th/28th will start becoming a focus late in the week as well as some pressure on the Russell from the rebalance on Friday. I would trade whatever the market gives us and I do expect some triple digit days. A successful reversal at this level could lead to another dramatic drop but once the bears become entrenched on Monday morning any concentrated bull rush could produce a true breakout rally over the prior highs. I would not hesitate to buy the breakout or short any failure. Friday's close was a nearly perfect setup for a big move in either direction.

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