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Financials Still Smoldering

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Two weeks after the resumption of the subprime hysteria the major financial stocks are still watching their market cap turn to ashes on a daily basis. This weakness in financial stocks helped turn Friday's opening bounce into yet another closing swoon. Add in the terrorist bomb discoveries in London and there was little cheering on Friday about the continued drop in inflation.

Friday's economic reports produced an opening bounce sending the Dow to a high of 13524 and a triple digit gain of 102 points. The leading economic mover was the Personal Income report for May. Income rose by 0.4% in May compared to a drop of -0.2% in April. The biggest component of the report was the Core PCE Deflator, which measures the rate of inflation at the consumer level. This is the Fed's favorite indicator for tracking inflation. The Core PCE rose only 0.1% in May bringing the year over year rate to 1.9% and the first time actually in the Fed's comfort range since February 2006. Inflation of 2.0% is considered to be the top of the Fed's comfort range. Spending also rose by 0.5% suggesting consumers have not been completely wiped out by the hike in gasoline prices.

The Chicago Purchasing Managers Index (PMI) slipped slightly in June to 60.2 compared to 61.7 in May. This slight drop was much better than analyst expectations for a drop to 58.0. This suggests the economic momentum is continuing. The Goldilocks conditions of moderate economic growth and slowing inflation still appear to be intact and that should keep the Fed on hold. Based on Friday's PMI the forecast for the ISM on Monday is for a modest decline to 54.5 from the 55.0 level we saw in May.

The NAPM-NY report showed a continued improvement in conditions in New York with a headline reading of 451.5. The current conditions component spiked sharply gaining 17 points to 52.5. The quantity purchased component also rose sharply from 50.0 to 71.4. This shows the New York City economy is rebound strongly from the Q1 dip and business is booming!

Construction spending for May increased by 0.9% to $1.177 trillion led by a 2.2% jump in public construction. That was -2.8% lower than the same period in 2006. A -0.8% decline in residential construction kept the gains in private construction to 0.5% overall. This is not a market moving report but just another confirmation the overall economy is still growing moderately.

June Consumer Sentiment recovered slightly to 85.3 from the initial June reading of 83.7. That initial reading was a monster drop from May's 88.3 and while the final revision is better it is not that much better. Overall sentiment is steadily declining and that is directly impacted by the housing problem and high gasoline prices.

Consumer Sentiment Chart

It was a year ago Friday that the Fed raised rates for the last time. Based on the current economic scenario it could be another year before they change rates again and that could be an error. With the housing sector going down in flames and given another shove lower by the new mortgage guidelines the Fed may need to cut rates soon to prevent a complete meltdown. There are no signs on the horizon of any rate change after last week's comment on inflation. The Fed said, "A sustained moderation in inflation pressures has yet to be convincingly demonstrated." This suggests they want to see it progress to the midpoint of their target range at 1.5% before making any moves. I think I heard somebody say something about a cold day in hell before that happens in this economy and high oil prices.

Next week's calendar is not as busy as last week but there are three critical reports. The ISM report on Monday is expected to show continued moderate growth and at this point will be a confirming indicator rather than a leading indicator unless there is a significant deviation from the expected headline number of 54.5. On Thursday the ISM non-mfg index is expected to show a slight decline to 58.0 from last months strong gain from 56.0 to 59.7. That reading was the highest since April 2006. On Friday we get the June Employment Report, which is expected to show a gain of 130,000 jobs. This compares to the May gain of 157,000 jobs. Job gains have been averaging slightly under 150,000 jobs per month but the two smallest gains in the last year, Apr 80K and Feb 90K, came in the last four months. The country requires new job creation of about 150,000 per months to absorb the new workers moving into the system from immigration and graduations. A number significantly under the 130K June estimate would be Fed friendly but probably market negative. With all the production reports showing slight declines a drop in employment could bring back fears of a future recession. It appeared we had dodged that bullet once the economy rebounded out of Q1 but we need that rebound to continue.

Economic Calendar

There were four major topics making news on Friday. Those were subprime loans, oil over $70, London terrorist bombs and the iPhone debut. The subprime loan problem at Bear Stearns rebounded back into the spotlight on news the SEC was accelerating their investigation into the collapse of their subprime funds. Bear Stearns announced new management at the top of the division that overseas those funds. With the investigation accelerating the various financial stocks took a serious hit on the last day of the quarter. It appears fund managers did not want to show any subprime exposure in quarter end statements to investors. BSC lost -$4 but that was $2 off its lows for the day. GS -2.21 and MER -2.44. Washington Mutual said they were going to refinance $2 billion in subprime loans at discounted rates to assist homeowners in stabilizing their finances and avoiding foreclosure. $400 billion in subprime debt will begin to their first reset in August to current interest rates. With subprime delinquencies already at 13.77% and alt-a loan defaults rising to 4.21% there is still a lot of pain ahead for mortgage companies and consumers.

Federal regulators tightened loan guidelines on Friday saying borrowers should not be penalized for refinancing out of a low introductory rate. They also said lenders must have evidence borrowers can repay at the highest possible rate during the term and lenders must warn a borrower 60 days in advance of a pending reset. Restrictions to low-doc loans were increased with stipulations they would be the exception rather than the rule. Some lenders had hoped regulators would provide an escape clause to allow low-credit borrowers to refinance without meeting the stringent new credit standards. Friday's notice slammed the door shut on that hope. The new guidance was issued by the Fed, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp, the Office of Thrift Supervision and the National Credit Union Administration. That pretty well covers all the bases and should produce yet another round of pain in the housing sector. Since financials are the largest component of the S&P this day long selling helped to erase the morning's gains.

Oil prices have flirted with $70 for the last two weeks and finally closed over that level at $70.50 on Friday. Ironically oil inventories in the US are very strong and at levels not seen since 1998 when oil was under $20 per barrel. The challenge is the low refinery utilization under 90%, continued strong demand for gasoline with the peak demand still ahead, geopolitical concerns and the impending hurricane season. As we get farther into hurricane season the other factors weigh more heavily. If a hurricane heads into the Gulf of Mexico the lack of refinery utilization could get substantially worse. In 2005 several refiners were offline for over a month. If that happened today we could see a late summer gasoline shortage even with decade high levels of oil in inventory. For the last 8-weeks gasoline prices have averaged $3.10 per gallon and despite the high price U.S. gasoline demand has been stronger than the prior year in 7 of those 8 weeks. Traders are talking about $80 oil by the end of summer but without a hurricane soon we could see a point where traders will reconsider being long. 2006 failed to produce any material hurricanes and so far 2007 is proving to be a carbon copy but there is plenty of season left.

Gasoline Demand Table

August Crude Oil Chart - Daily

The two terrorist bombs found in London captured the headlines and helped to cause considerable unrest in the equity markets. These park and forget bombs can be created very inexpensively and can cause a lot of causalities. The fear is that the U.S. has been relatively unscathed by terrorist activities since 9/11 and we are completely exposed to nearly any form of car bomb attack. Our heavily mobile society is a prime target for this type of attack. Personally I find it very hard to believe we have not seen dozens of car bombs in the U.S. before now. This type of event in London just reinforces the awareness of how easily we could be targeted. The administration held an emergency meeting in the White House on Friday afternoon to discuss our plans for preventing this type of attack. News of that meeting helped keep a cloud over the markets all afternoon.

Ebay IPhone Auction

The event capturing the most headlines on Friday was the launch of the iPhone. People waiting in line at the various phone stores, some since Monday, were selling their seats for $400-$700 to latecomers. Most of those inline were planning on buying the limit of 2 phones per person and selling the second phone for a profit. The auction above was posted by an individual claiming to be #25 in line at the Apple Store in Connecticut. He is auctioning off his second 8GB iPhone and bids have already exceeded $15,000. This is the height of insanity. I doubt #25 will get his iPhone payment because prices on Ebay began to crater as the night grew older. New iPhone listings began to appear with buy it now prices under $1200.

Numerous analysts were taking up airtime talking about Apple expectations being priced into the stock and the potential for a disappointment next week. That was nothing new to me as everyone reading my commentary already knows I am long Apple puts going into the iPhone release. Reports from across the country claim many AT&T stores were limited to 250 phones in this first shipment. (1800 stores = 450,000 phones) Apple stores were said to have considerably more inventory. With lines running 250-500 people deep reporters were questioning if supplies would hold but late Friday night there was still no news of any sellouts. Even Apple co-founder Steve Wozniak was waiting in a line in California along with other long time Apple employees. They could have gotten their phone through channels but they elected to feed the hype by camping out with consumers. Wozniak admitted this was the first time he had slept outside all night long since 1972 when he waited in line to get Rolling Stone tickets. Analysts expected 400,000 units to be sold this weekend. Late Friday the Associated Press reported demand at many AT&T stores was so heavy their computer system was having trouble across several states. The WSJ said numerous locations were having to process sales manually and others said sales were at a complete standstill. USA Today quickly put out a review based on first impressions from numerous new users. The lead comment was "not perfect but worth the hype." The NY Times exit poll said, "The iPhone matches most of its hype." Some may have seen the iPhone release on Friday morning on the Today Show. Neither iPhone supplied to the show for an on-air promotion would work. Also, you can't activate it at the stores. You have to go online at iTunes.com to active the phone.

TThe real key will be what happens when all these buyers get the phone home and activated. Will any glitches appear in the news on Monday to dampen the hype? Friday's mob scenes were already priced into the stock with a 50% move since December to close at $120 on Friday. Next week will determine if that hype was justified. We saw RIMM post blowout earnings this week with a monstrous increase of 1.2 million new subscribers in the quarter. Revenue jumped 76.5% and was helped by new Blackberry products. I contend it was helped by the iPhone hype. People saw their mental budgets stretched by gazing at the $600 iPhone price tags and after reviewing the comparable features they elected to buy a Blackberry over the last quarter rather than wait for the iPhone release. You may have noticed that AT&T has been running a BlackBerry Curve ad for months now right behind the Apple ads for the iPhone. Smart marketing on the part of AT&T. Those buyers who did not want to wait for an expensive unproven phone were mentally prompted to take the plunge on a BlackBerry instead. Numerous business customers claim the Blackberry is better suited for business where the iPhone is consumer oriented. RIMM should thank Apple for hyping the phones to such an extent over the last six months. RIMM closed up $34 on Friday at $200.

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One more paragraph on the iPhone and I promise I will refrain from using the "I" word for at least a week. Analyst Brett Arends posted a list of 5 reasons not to buy an iPhone on Friday. First you have to pay AT&T for calls. You can't make VOIP calls over any WiFi network in range as you can with other smart phones. It also does not use the super fast 3G AT&T network but uses the slower and technology obsolete 2004 vintage Edge network. The Nokia e61 smart phone can use WiFi networks and VOIP over those networks saving a bundle on minutes. You can use WiFi networks to browse the Internet with the iPhone, just not make VOIP calls. You can't change networks so no roaming out of the AT&T family. You are locked into AT&T for 2 years no matter what. At the minimum plan that is $2,000 for the privilege of impressing your friends. No 3rd party software is allowed on the iPhone unless it runs on the Apple Safari browser. That means limited selection and limited functionality according to Brett. You can only download songs or other content while connected to your PC. You can't download songs, news, video, etc, while waiting in an airport or stuck in a hotel room unless you bring your laptop along. With the Nokia you can download content anywhere you have a connection and use 3G or WiFi to do it. For such a revolutionary phone it is amazing how many feature it does not have that would have been so easy to add. Apparently Steve Jobs thought restricting you to paying for content through iTunes was a better business model than giving you open access. Thank you Brett for the list! I am done, no more iPhone ranting for at least a week. Maybe I will go shop for a new BlackBerry this weekend. (grin)

Next week is the last week before the Q2 earnings cycle begins. We are likely to see some warnings from people who hope to slip by unnoticed with traders out for the holiday week. Official S&P earnings estimates are still for 4.1% growth but hardly any analysts are publicly preaching less than double that. Unfortunately warnings for the quarter, although light, have numbered more than positive pre announcements. Can the CEOs make it through another quarter of under promise and over deliver? We will know very soon. The energy sector is expected to seriously outperform with oil prices well over $60 for most of the quarter. The implosion in natural gas prices did not occur until last week so plenty of profits there as well. The consumer sector performed poorly and earnings are not going to be fun. Nearly all the major consumer stores like HD, BBY, CC, etc, have warned and estimates for retail earnings have fallen by -10%.

The Russell rebalance is over. Any end of quarter window dressing has also passed. I did hear more funds claiming they were exiting positions to avoid exposure than funds claiming they were still buying the leading names. A new statistic popped up on Friday that would seem to run contrary to the window dressing theory. After Friday's loss the S&P has closed negative on the last day of the quarter for 11 of the last 12 quarters. Is it that funds are window dressing earlier and that last day is finding more shorts hoping to capitalize on the following week's undressing process? That is one theory but theories are like noses, everybody has one.

The Dow was extremely volatile on Friday with a 102 opening spike, a -210 point reversal to a low of -108 and a closing rebound of 95 to close nearly flat for the day. It was a roller coaster ride but support held. In the chart below the Dow continues to hold over uptrend support but it looks to me like there is more risk to the downside than potential for a rebound. The Dow has been holding on this support for a week and could not manage a credible rally. The longer the Dow spends at this level the better the chance we will see a support break and a potential retest of 13200 or lower. With financials and homebuilders likely to drop further we could easily see that Dow support crack.

DDow Chart - Daily

The Nasdaq has performed a lot better than the Dow and could offer the best hope for the overall markets. If tech stocks continue to show investor interest we could see that interest spread to the other indexes. The dip buyers in techs are alive and well and keeping the Nasdaq in its longer term uptrend. This gives the Nasdaq plenty of support at multiple levels from its current 2600 close down to 2525 and a level that must not break. With plenty of room to relax without any danger it removes the anxiety for the tech bulls and makes them even bolder.

Nasdaq Chart - Daily

The S&P-500, like the Dow, is struggling to hold over critical support at 1490. Were it not for techs and energy the fight would already be over and a different conversation in progress. If there was any window dressing last week the S&P did not show it with a whopping 0.79 point loss for the entire week. Maybe that was window dressing that kept it above support and out of trouble. If there was window dressing then as sure as night follows day next week will see window undressing and the S&P has only about 12 points it can spare before going critical again at 1490.

S&P-500 Chart - Daily

I am betting that low volume next week could favor the sellers since the bulls have been unable to produce a credible rebound attempt for a week. Four of the last five days saw an afternoon decline that erased the morning gains and that is clearly a sign of rising conviction from the bears and lack of confidence by the bulls. They are buying the news events but can't hold the gains. With Friday's late afternoon tightening of credit guidelines this could continue to depress financials on Monday. Monday's ISM is a wild card but unless it deviates a lot from the expectations it is not likely to be a market mover. It is a holiday week and volume should be light. Volatility is likely to fade and trading could be like watching paint dry. However, if support breaks even those junior fund traders forced to work on a holiday week can still hit the sell button. Buying may take more planning and agreement coupled with a few calls to the Hamptons but selling is nearly automatic if a real decline begins. Stops are already in place and are waiting like landmines to be tripped. Personally I am slightly biased to the down side simply because it appears to be the path of least resistance and there should be a lack of events capable of producing an upside surprise. Choose your plays for next week but wait for confirmation of your direction before taking the plunge.
 

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