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Market Wrap

Expect the Unexpected

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Q2 earnings began yesterday and instead of the expected upside surprises we saw a flurry of earnings misses and earnings warnings. Add potential downgrades by S&P on billions in bonds backed by subprime mortgages and an inflation speech by Bernanke and you have a recipe for disaster.

Dow Chart - Daily

Nasdaq Chart - Daily

Economic reports had little impact on the market with no surprises on the scheduled reports. Chain store sales were flat at 0.1% for the week. Job Openings were unchanged at 2.9% while the hire rate rose slightly to 3.6% from 3.5%. Separations fell to 3.2% from 3.3%. Yawn. Wholesale inventories rose 0.5% in May while sales rose 1.3%. April was revised higher to a 1.5% gain. This was a moderately strong report with the inventory to sales ratio falling to 1.11 and a level not seen in many years.

Those marginally positive economics were the extent of good news for the day. All the other news items weighed on market sentiment and depressed the indexes. Leading the list of concerns were Q2 earnings.

Alcoa led the list with an unexpected drop of -4% in their quarterly revenue. Outages at two U.S. plants helped cause the drop. Earnings of 81 cents per share were below the 85 cents posted in the comparison quarter. This was a minor downside surprise but it set the stage for those earnings warnings to come.


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Before the open on Tuesday Home Depot warned that it was lowering its full year estimates for 2007 due to the implosion in the housing market. Ok, we have heard about the housing implosion for months so what was new today? The new problem was the severity of the warning. Home Depot now expects full year earnings ex-items to be in the range of $2.30-2.36 with the analyst estimates at $2.54. This haircut was a substantial drop in estimates and represents a drop in earnings of 15-18% over 2006. CEO Frank Blake said, "Looking at the overall market there is still a correction that lies ahead of us." Despite the severity of the warning HD still finished the day in positive territory. Unfortunately the rest of the sector turned to ashes around them. HD held its recent gains because of their open tender offer to buy back 250 million shares between $39 and $44 by August 15th. That will keep a floor under HD until August 15th. The next lift for the stock will be the $10 billion buyback scheduled in October once they complete the sale of their Home Depot Supply division. The other names in the sector don't have those factors supporting their stock prices.

Adding to the housing implosion fears today was another a warning from DR Horton (DHI). Horton said the spring selling season was a bust for them with sales falling -40% for Q2. Horton said it would post a quarterly loss for the first time since going public in 1995 due to the drop in sales, write down of existing homes and contracts and losses in land options. Horton took orders in the quarter for 8,559 houses worth $2 billion. This compares to orders for 14,316 homes worth $3.8 billion in Q2-2006. Order cancellations rose to 38%. The inventory of unsold homes is currently at 8.9 months of supply and the highest level in 15 years.

XHB - Homebuilder ETF Chart - Weekly

Sears Chart - Daily

Sears (SHLD) warned that earnings would disappoint because of slowing sales at its Sears and Kmart stores. Earnings are now expected to be $1.06 to $1.32 compared to analyst estimates of $2.12 per share. SHLD lost 10% of its value or -17.20 to fall to a new ten-month low. For the week ended July 7th same store sales fell 3.9% at Kmart stores and -4% at Sears stores.

WD-40 Company also warned that earnings would be less than expected due to a variety of reasons. New earnings estimates from WD-40 were in the range of $1.70-$1.75 per share compared to prior estimates or $1.70-$1.85. Analysts were expecting $1.78 per share.

Acuity Brands (AYI) reported earnings that were 35% over the comparison quarter but shares fell -5.5% due to concerns that slowing construction of homes and shopping centers would decrease the demand for their lighting products.

Chattem Inc (CHTT) reported earnings inline with the street and raised guidance for 2007 but the stock fell -$4.29 on the news.

Not all earnings produced a loss in the stock price. Greenbrier Companies (GBX) a maker of rail cars spiked 4.52 or 16% after reporting earnings of 81 cents that more than doubled analyst estimates for 39 cents. Rocky Mountain Chocolate Factory (RMCF) reported earnings that grew 11%, predicted future growth of 15% to 20% and said it was going to issue a dividend of 5 cents. This produced a 6% spike in the stock price. Obviously you had to significantly outperform to overcome the earnings negativity in order to produce a gain today.

If early cycle earnings problems were not bad enough S&P announced it was downgrading 612 classes of mortgage backed securities representing $12 billion in subprime debt. This was not unexpected by bond traders but the severity of the warning was surprising. S&P said, "The levels of loss continue to exceed historical precedents and our initial expectations," and "We do not see the poor performance abating." S&P said they expect average housing prices to fall -8% from 2006 to 2008. Moody's also said they had downgraded 399 different mortgage backed securities and placed 32 on credit watch. The $12 billion was only 2.1% of the $560 billion in mortgage backed securities sold in the 2006 period in question. The period producing the most defaults were those loans written in late 2005 and early 2006. The problem is not really the initial downgrade but the ripples across the sector. Now that the official downgrades have begun the need to mark down the other $500 billion in debt is fast approaching. Since many institutions have been carrying this "investment grade" debt at full value the cut to below investment grade requires a mark down on their books. It will also produce drops in valuations in CDOs written with this debt as the collateral. With 20-1 leverage common across this type of instrument there could be tens of billions in write-downs needed. This story is far from over and nobody knows where it will end. We still do not know for sure who is actually holding this debt and the CDOs written from it.

As if the markets did not have enough to worry about FOMC chief Ben Bernanke took to the microphone to discuss inflation expectations in Cambridge Massachusetts. Traders feared the worst and hoped for the best and were disappointed on both sides. Uncle Ben gave a textbook speech on inflation and said nothing about the current economy. It was a dry, academic speech and the Q&A afterwards failed to produce any insight on the current Fed mindset. This was frustrating to traders who had hoped uncle Ben would toss out a couple comments to support the market and convince traders that inflation was at bay. While he did not say anything positive he also said nothing negative. The markets had recoiled from the morning's earnings warnings and were holding at -40 or so on the Dow as the speech progressed. Once it was clear there would be no lifeline thrown to the markets the sellers appeared in volume and the technical indicators began to crumble.

Even the energy sector saw a bunch of losing issues despite oil prices breaking the $73 barrier intraday. Profit taking was evident in those that had gained the most in recent weeks. The surprise warning from the International Energy Agency (IEA) kept support under crude prices. The IEA warned that oil demand was rising at a 2.2% rate annually and would continue to do so through 2012. At the same time global production is only rising by roughly 1% per year. The IEA has finally seen the light and after years of dismissing peak oil as a fairy tale they are starting to ring the warning bell. Amazingly their prior predictions of plenty through 2030 were seen as gospel by the consuming nations. Now that they are warning of an impending shortage their claims are being ignored as a ploy to gain attention and support big oil companies. You can't have it both ways. If you believed them when they were predicting demand and production of 130 mbpd by 2030 then you should believe them now when they say production expectations are not meeting with reality. Demand is expected to reach a record level of 85.6 mbpd by Q4. I know I am preaching to the choir here but $100 oil is coming and it will be followed closely by $125 and even $150 oil. Once demand exceeds supply by even 50,000 bpd the price will no longer be controllable by anyone including OPEC. It will become a permanent bidding war and within 10 years we will be wishing for $5 gasoline.

August Crude Futures Chart - Daily

Wednesday will be devoid of any material economic reports with only Oil Inventories and Mortgage Applications on the schedule. We already know mortgage applications have been falling for weeks and last week is not expected to be any different. Earnings highlights will be DNA, YUM, CHAP, RT, STD and MBWM. Not exactly a market moving earnings list.

The challenge for Wednesday will be overcoming the negative momentum from Tuesday. The declines may have made the headlines but the losses are minor in the greater scheme of things. The Dow declined -148 points to 13497 but still remains well above the lows seen just last week at 13316. It is too early to proclaim the end of the bull or the arrival of a summer correction. One day does not make a trend. As long as the Dow remains above 13350-13400 the bull market is intact. Under 13300 and analysts can start talking about summer correction.

The Nasdaq lost -30 points and a very respectable decline but at the 2640 close it is still well above its 2575-2585 support level. Techs have been hot with chip stocks leading the charge. The SOX hit a new 52-week high at 522 on Tuesday led by Intel and Texas Instruments. Intel reports earnings next Tuesday. It is rumored they will cut prices on existing chip models by 50% on July 22nd. This will further crush AMD just as AMD prepares to announce its next chip release.

The S&P-500 lost -21 points and was the biggest loser of the major indexes with a -1.41% loss. It was also the leader of the drop. When the S&P futures broke through technical support at the 50-day average at 1530 the selling accelerated. The S&P actually looks the most bearish of the three majors and the only one to close under the 50-day. 1490 remains strong support but the pattern currently forming suggests the next support test could fail.

SPX Chart - Daily

Today's losses were primarily news driven and represented a small flight to quality and some trailing profit stops getting hit. Declines beat advancers 3:1 and declining volume was better than 4:1 over advancing volume. It was a sharp news driven event. Tomorrow will be the key. Hopefully cooler heads will prevail and the bulls will be back in dip buying mode. I suggested in the weekend commentary that I would buy any breakout over 1540 but short any failure at 1535. Monday's high was 1534.26 and the failure there was close enough for me to enter a short going into Monday's close. It is just a trade and not a prediction on the market. Until that 1490 support is broken the rally is still intact. I would just be a lot more cautious if it appears that support will be tested again soon.

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