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Market Wrap

Fed Worries Take Center Stage

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Even though the Fed is not expected to make any changes to interest rates or to their statement the markets traded on edge ahead of the meeting. For five days now various factors have joined to spoil market sentiment and while the losses were light today a new trend has appeared. Bulls are still buying the dips but bears are having a lot of success selling the rallies ahead of the Fed meeting.

Dow Chart - Daily

Nasdaq Chart - Daily

It was not a good day for economic news. The first report this morning was Consumer Confidence for June and analysts were surprised with the headline drop to 103.9 from 108.5. Consensus estimates were for a smaller decline to 105.5. The present conditions component was mostly responsible with a -8.3 point fall to 127.9 from 136.1. The expectations component fell only 2.2 points from 90.1 to 87.9. All the other components worsened as well but to lesser degrees. High gas prices, stock market weakness, housing weakness and the resurgence of the subprime headlines all combined to weigh on consumer confidence.

New home sales fell slightly in May to an annualized rate of 915,000 from 930,000 in April. Inventory increased to 7.1 months but is still below the high of 8.0 months we saw back in February. Sales declined -1.6% from April and are down -15.8% over the same period in 2006. Since Apr/May/Jun are the peak selling months the drop in sales and rise in inventory is not encouraging. Even more disconcerting was the -50,000 revision to the April headline number from 980,000 to 930,000. The only signs of stabilization appeared to be due to a drastic slowing in construction activity. Builders are showing no interest in adding to inventory as fall approaches.

The only report showing a positive jump was the Richmond Fed Manufacturing Survey. The headline number jumped back into positive territory at +4 after spending five months around -11. This was the first positive month since November. Shipments rebounded from -7 to +7, new orders to +6 from -13 and order backlogs improved from -18 to -5. The only decline came in the six-month outlook, which declined to +21 from +30. Overall this was a confirmation that business conditions are improving and could be improving rapidly. This is good news for traders and bad news for the Fed ahead of their two-day meeting, which begins tomorrow.


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The big news today came from homebuilder Lennar (LEN) when it warned that they were continuing to see weak and perhaps even deteriorating market conditions. Lennar posted a loss for the quarter of -$244.2 million compared to a profit of $324 million for the same quarter in 2006. Revenue slid to $2.88 billion from $4.58 billion. Margins had fallen to 13.6% from 23.7% in 2006 and that drop was attributed to falling prices and higher incentives. Average incentives are up to $43,700 per home compared to $24,700 a year ago. Cancellation rates are holding at 29% with buyers having trouble selling their existing homes. Lennar has cut back on new starts by more than 50% to reduce inventory. Most of their loss for the quarter came from costs associated with 5,400 home sites under option that they have decided not to purchase. This news continued to pressure stock prices in the sector with LEN falling to a four-year low at $37.50, a level not seen since Sept-2003. TOL, NVR and KBH are showing slightly more underlying strength but all the builders have either broken or are close to breaking multiyear support levels.

Blackstone Group (BX) hit a new low of $30.20 and under its $31 offer price. Fears about higher tax rates and increased hedge fund regulation is pressuring the price. Fortress (FIG) also hit a new historic low of $21.90. Fortress went public at $18.50 but never traded there with a first day close of $31.

Google closed at a new historic high at $530.30 despite a pass by a Federal judge on Google's complaint against Microsoft and Vista. The judge who has been handling the Microsoft antitrust settlement since 2002 said Google would have to take its complaints to the Justice Dept and the individual states. Google is complaining Vista's desktop search unfairly restricts competition much like the inclusion of the Explorer browser supposedly restricted competition from Netscape. Google was trying to get this feature included in the 2002 antitrust agreement. Last week Microsoft promised it would build into Vista an option to let users select a default desktop search program for windows users. A lawyer representing several states said this was a reasonable solution to Google's complaint.

After the bell today Oracle reported earnings that beat the street by two cents on sales that rose +17% from the year ago quarter. Analysts had expected growth of 13-14%. Oracle claims it is taking market share from rivals IBM, SAP and BEAS. Oracle CFO, Safra Catz, said Oracle sales could rise as much 20-30% in the current quarter and more than double analyst estimates. However, Oracle's actual earnings forecast of 21 cents was inline with analyst estimates. ORCL was volatile in after hours but closed the session up +19 cents after the news.

Nike reported earnings that were inline with estimates but sales jumped +32% due to strong overseas gains. Nike (NKE) stock surged +2.91 (+5.4%) in after hours on the news. They said future orders rose +12% for the quarter. They saw strong gains in Europe (+12%) and Asia (+7%) and +10% gains in the United States.

Only three days until the iPhone launch and the hype just keeps building with Apple ads running on every network at nearly every commercial break. That is producing even more concern for me since they already know they are going to have a blowout product launch and more demand than they can fill. Why spend tens of millions of dollars to advertise a product most will be unable to buy for months to come. I understand the whole branding thing but I am beginning to suspect there is a problem ahead. Have you ever noticed the movies, which are advertised the most ahead of the release, are almost always duds? The company knows the picture did not turn out as good as they hoped and their only chance at a profitable run is to flood the theaters with viewers on the first weekend before word of mouth kills future attendance. They will spend millions getting viewers into those seats in an attempt to recover as much as possible before viewer expectations go down in flames. I don't expect the iPhone to be a bust but there could be some problems that have not been made known yet that could diminish demand. The bandwidth issue is the biggest problem reviewers have questioned and a 10-15 second screen change instead of 1-2 seconds as shown in the commercials could be a big challenge. I fear Apple is going to build the excitement to a fever pitch by this weekend but the majority of shoppers will find supplies quickly sold out. Frustrated buyers may then opt for a competitor phone like the Blackberry or Palm. That pent up shopping urge has got to go somewhere once consumers have made the decision to spend $600 for a phone. That $600 is only the start. Apple announced their service plans today with prices ranging from $59.95 (450 minutes) to $219 per month. That is not a misprint. Not only will you have to pay $600 for the phone but a minimum of $1440 in monthly charges over the life of the two-year contract for only 450 minutes a month. The $219 service plan covers 6,000 minutes per month. Assuming you sleep at least once a day that represents nearly 20% of your waking hours would be spent on the phone. It will be interesting to dissect the iPhone launch a couple weeks from now to see if reality equals the hype and if customers actually stepped up to the counter with credit card in hand. In New York lines are already forming outside AT&T stores so at east a few people have completely bought into the hype.

The Bear Stearns problem continues to rile the markets despite comments from Merrill Lynch and others that the panic was seriously overblown. New reports from others in the field claim leverage rates of as much as 40:1 and they claim the worst is not over. Bear Stearns claims they will be able to successfully "de-leverage" the funds but it will take time. The SEC announced it has launched 12 probes into the CDO sector to decide if there is anything to prompt greater concern. However, most of these deals are private deals and do not come under direct SEC jurisdiction. Several analysts are warning that we are going to see a serious write down of assets in the coming earnings cycle due to maturing portfolios and the mark to market requirement. One analyst said Merrill was still carrying assets on the books despite the loans being in foreclosure and in some cases already foreclosed and gone. There is also concern that the major banks will end up holding the paper when the smoke clears and their book losses will be huge. This could take another year to play out but we should see the early signs with this quarter's earnings reports.

We can expect oil exports from Venezuela to decline at an increased rate over the next couple of years. It was announced today that ConocoPhillips (COP) and ExxonMobil (XOM) would be leaving the country rather than agree to the Chavez nationalism plan of their projects. Chavez gave the six foreign companies until May 1st to turn over 60% control of their assets to PDVSA, the Venezuelan national oil company. Under the nationalism plan the foreign companies could retain a 40% ownership stake but face significantly higher taxes on the oil produced. What a deal! You give us 60% control over your assets and we will charge you an extra 50% in taxes on whatever you produce. COP and XOM said no deal. Chevron, BP, Total SA and Statoil reluctantly agreed and signed papers on Tuesday. Total saw its ownership slashed to 30.2% and Statoil to 9.7%. The six companies had invested more than $17 billion in their respective projects and had more than $4 billion in outstanding debts related to those projects. There was no provision for the debts under the new ownership rules and Oil Minister Rafael Ramirez said those loans are the responsibility of the individual companies and PDVSA would not be assuming any obligations. I am sure those four companies that stayed did so in hopes they could eventually recover their initial investments. In the case of Conoco and Exxon they feel they have a better chance in the world court but I would not bet on getting any money back even if the court rules in their favor. Both companies and PDVSA claim to still be in talks but those talks are not producing any results. The projects abandoned by Conoco and Exxon will be taken over by PDVSA and that is where the problem lies. PDVSA does not have the depth of experience, the technology or the money to continue current production levels and exploration efforts. Chavez is siphoning off all available funds to pay for the social welfare programs keeping him in office. Production has been declining for several years and it is a historic fact that PDVSA projects fail to maintain historic production levels. Without Conoco and Exxon and their vast expertise and cutting edge technology the problem is only going to get worse. Don't expect the players who remained to contribute large amounts of capital to fund future exploration to only get back a fraction in returns. Oil production from Venezuela will decline over the coming years and we can count on it.

Oil prices have already built in a Chavez premium over the last year as the pending nationalism terms were announced. There was no change in price due to today's announcement. Oil prices did fall -$1.38 to support at just under $68 on news that the Nigerian strike had ended and some production would be coming back online in the coming weeks. Traders also feared tomorrow's inventory report after last week's +6.9 million barrel spike. After weeks of no gains the sudden surge caught traders off guard. They are worried about a duplicate event tomorrow. Personally I believe it was an import timing issue where numerous tankers showed up all at once and that produced the spike. Imports were up +650,000 bpd over the prior week's average. That is 4.5 million barrels right there in increased imports. Refinery utilization fell to 87.6% as problems continued growing and they simply could not react to the sudden influx of crude. Personally I would not be surprised to see a flat report or even a draw down in those levels but it all depends on timing of those deliveries. I doubt there was a sudden 6.9 million jump in production somewhere. Since tankers are contracted and loads scheduled for months in advance it is even more unlikely there was a sudden uptick in shipments. More than likely what we saw was the result of that typhoon in the Straits of Hormuz. Tanker traffic was delayed out of the Persian Gulf for 5-7 days and once the storm cleared those tankers loaded for the U.S. all left the Persian Gulf at the same time providing us with our inventory spike upon their arrival.

The two-day FOMC meeting begins tomorrow and while nobody expects any change in posture it appears nobody is willing to bet against it. Volatility has returned ahead of the meeting as traders position themselves for a worst-case scenario. The continued weakening in the housing market and the Bear Stearns subprime blowup should be more than enough to keep the Fed on the sidelines. The recent trend of positive economic reports is more than offset by the housing news. If there were any chance of a change to the posture this week I would think it would be towards lower rates not higher. It may take lower rates to produce a bottom in housing and if the Fed waits much longer the buying season will be over and the new loan guidelines slated for September will restrict even more sales.

The market trade for this week will begin with the Fed announcement at 2:15 on Thursday. Until then we should be on hold at our current levels. We have seen triple digit reversals on both days this week and better than 100 point Dow moves on 8 of the last 16 days of trading. The volatility index (VIX) closed at a new three month high today at 18.89 and that is right at the daily highs we saw back in February. The VIX increases because traders are willing to pay more for puts to cover potential market declines. It would appear traders are truly concerned that the current trend lower could continue. I am sure we are also seeing increased put buying ahead of the Fed meeting that is also spiking the VIX.

VIX Chart - Daily

The Teflon Dow has given up -400 points since the June-15th high and it is resting on support on the 50-day average at exactly where I would have expected it to stop. This is a critical level and a breakdown here could get serious very quickly. Today's close at 13337 is right on the edge of a very steep cliff that even Wiley Coyote would shy away from. It would be nice if I could say the last two days of losses had occurred on light pre-holiday volume. Unfortunately volume has been heavy with a 6.0 billion shares on Monday and over 6.1 billion today. That volume has been weighted 3:1 in favor of down volume and better than 2:1 in favor of decliners over advancers although today was slightly better.

The Nasdaq continues to be weak with support still about 10-15 points away at 2560. Networkers and biotech's have been strong while chip stocks led the declines.

The S&P has also declined to close exactly on critical support at 1490. The stage is set for either a dramatic change in the market to new multi month lows or a post Fed rebound. This week is the end of the quarter and you would expect some serious end of quarter window dressing to appear. If it is going to show we may have to wait for the Fed announcement. A fund manager does not want to be caught going long with all his available cash only to have the Fed change direction and tank the market several hundred points the day before the quarter ends.

S&P-500 Chart - Daily

This may be too much speculative fiction and short on hard facts but at this point in the quarter, earnings cycle and market cycle there is little else we can do but speculate. The only hard fact is how quickly we could fall if the current support levels break. They are at critical points that could have a profound impact on the market if they break. I shorted the futures when the market began to roll over this afternoon and being short I watched the tick-by-tick market action closely. There was substantial support at nearly every dollar increment all afternoon. It was crumbling only after a heated high volume battle at each level. At exactly 4:00 that support failed completely and the S&P futures took a sharp plunge of -8 points in just a couple ticks. This was duplicated on all the contracts, S&P, Dow, Nasdaq and Russell. That was a serious sell program and it obliterated afternoon support. This occurred only seconds after the cash market had closed. With an -8 point after hours futures deficit the morning open will be under pressure and that pressure could crack those support levels I mentioned above. I plan on remaining short with a trailing stop until the sentiment changes. Multiple days of triple digit reversals are very rough on market sentiment and a potential break of critical support is not going to improve it. Be careful on Wednesday and look for a major directional move after the Fed announcement on Thursday.

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