After weeks of rallies and rebounds on good news it is time for the bad news bulls to reappear and buy this earnings dip. Will they do it? I would not hold my breath but they have been showing up in quantity just when you thought they had left for vacation. Remember the prior Tuesday when the Dow lost -150 points intraday. The bad news bulls arrived to power a +400 point rebound. Remember back on June 29th news pounded the Dow to a -208 point intraday move. The bulls returned the next day to power a +350 point move over the following week. The bad news bulls are out there but they were nowhere to be seen on Friday.
Dow Chart - Daily
Nasdaq Chart - Daily
Friday had no important economic reports with Mass Layoffs and the Weekly Leading Index the only reports on the schedule. Mass layoffs in June rose to 1,219 events from 1,190 in May. The number of workers told to expect a pink slip rose to 127,897 from 119,089 in May. Layoffs had been averaging about 127,000 so May's dip was an exception and we are right back on trend. There was nothing for traders to worry about in this report. The weekly leading index was also flat at 143.9 and it would take a 10.0 move on the Richter scale to make anybody pay attention to this weekly report.
Next week is going to be busy with a headline report due out every day. There are three regional Fed surveys, two housing reports, the Fed Beige Book and the first look at Q2 GDP. The regional Fed manufacturing surveys are not expected to show any problems with steady but slow growth. The home sales numbers could not show any more negativity than is already priced into the market so any surprise would likely to be to the upside. The big reports for the week will be the Beige Book and the GDP. The Fed Beige Book is a report from all 12 Fed banks. Each bank reports on the economic conditions and trends in their area and the report is seen as a very specific update of overall economic conditions. Last month seven of the twelve banks reported modest or moderate growth and growth no worse than the prior reporting period. The other five banks reported stronger growth with improvement from the prior period. Traders will be looking for more banks to report stronger growth as evidence the recovery is still in progress.
The Q2-GDP is where the fireworks could start. Current official estimates are for +3.2% growth in Q2 compared to 0.69% growth in Q1. Whisper numbers have been over 4.0% in prior weeks but have cooled after some of the weekly economic reports were weaker than expected. The continued housing slump is also forcing a lowering of expectations. Bernanke said in his testimony this week that the slump was continuing and the bottom is still ahead of us. A jump from less than 1% to more than 3% could also ratchet up Fed rate expectations if it appears the economy caught fire and is suddenly accelerating. Conversely if the GDP comes in below 2% we could see expectations rise for rate cuts by year-end. The Fed needs to keep the economy on a growth cycle and if the bottom in housing is still ahead they may not want to wait for it to begin easing rates. Dropping the Fed rate indirectly impacts mortgage rates and buyer interest and could soften the landing when that housing bottom eventually arrives. With the Beige book on Wednesday and the GDP on Friday and three regional reports spread through the week the Fed watchers will have a busy schedule.
Earnings will be the focus next week probably even more than last week even though the five majors, IBM, INTC, MSFT, GOOG and EBAY have already reported. The market was hammered by some very high profile earnings misses last week and there were very few earnings reports. Because of the way the July 4th holiday fell on the calendar there are nearly 1200 companies reporting earnings next week. That is the busiest week I can remember. It means there is so much happening that only a small portion of the announcements will ever make it to the airwaves. Those will likely be the ones with the biggest disasters since bad news creates more attention than a company reporting inline with estimates or beating by a penny. I added a line to the earnings table below showing the number of companies reporting each day. This is only my rough count but you get the picture.
Last week there were some spectacular earnings disasters and they put a lot of stress on the markets. Intel reported a strong quarter but missed on margins and the stock was pummeled for a -$2 loss (-7.5%). Remember I cautioned that the biggest moves were normally a reversal of the pre-report trend. If the stock was already soaring on expectations then those expectations could be reaching unrealistic levels. Any minor flaw in the earnings or guidance or maybe just missing a hypothetical whisper number can knock multiple dollars off an inflated stock price. Even spectacular earnings can fail to push a stock higher that has already seen strong gains. Prime examples of this came from Intel, Google, Caterpillar, Mattel and Juniper. This just proves that if you are going to speculate on earnings and hold over the announcement your best odds are to bet against the trend.
Intel Chart - 30 min
GOOG Chart - 60 min
CAT Chart - 30 min
MAT Chart - 30 min
JNPR Chart - 30 min
If you take the earnings calendar from last week and chart each of the 46 companies I had listed you will find 9 that traded higher (BRCM on news not earnings) one flat and 36 that traded lower, most a lot lower. That was a 75% chance of a negative reaction to earnings and many of those companies posted decent earnings. The reason is simply an overextended market and overly optimistic expectations. I strongly advise you take 10 min and look at the charts for each of these companies. It could be an eye opener.
Last week's earnings reactions
Next week will offer investors plenty of reasons to take profits. Since there are an inordinate number of earnings reports in one week, well more than twice the average, there will be twice the number of sellers. If you are bullish and playing a stock for earnings then once earnings are reported you take profits and move on. The following week also has an abnormal number of reporters as the rest of the majors try to get it done before July is over.
To say last week was volatile would be an understatement. Twice the Dow set new highs and twice there were -200 point intraday reversals. The Nasdaq equaled that with two new highs and two -50 point reversals. This is not a normal event but typical of frothiness at a market top. There are quite a few things weighing on the markets and some of them are serious. We heard from several sources last week that the subprime slime has not gone away and will likely get worse. Bear Stearns (BSC) reported that their two subprime hedge funds, worth $1.5 billion in Q1 were now worthless. They were busy hiring lawyers to defend against he various suits already headed their way. Many of the major banks and brokers who had earnings last week reported taking charges to double or triple loan loss reserves for the problems they see coming in their own portfolios. Uncle Ben reported that the housing slump would get worse before it got better but it appeared to be contained. That means the eventual damage, now expected to be in tens of billions, will be confined to deep pocket investors and no institutions are expected to fail. That is good since Fed President Poole was on the wires on Friday saying the Fed should not be planning on any subprime bailouts.
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The subprime problem may not be as contained as Uncle Ben thinks. Or maybe it is just a guilty by association factor now impacting private equity deals. With regulators trying to raise taxes on private equity firms at every turn and lenders starting to reappraise their risk appetite there are cracks starting to show in several LBO deals. The LBO firms have to sell debt to close their deals and the price of debt is rising quickly as lenders raise the stakes for these sometimes high-risk deals. One $22 billion deal in England, the largest ever done there, was reportedly in trouble on Friday as the closing date approached. Another deal, the multibillion Chrysler/Cerberus buyout, is coming to market next week and traders are expecting a less than enthusiastic reception for the debt. Reportedly Cerberus has all the necessary commitments from banks but the market is still on edge until they see the pricing next week. Reportedly $62 billion in debt will be required to complete the deal. $10 billion was supposed to fund at 3.25% over Libor is now being quoted at 3.75%. An additional $2 billion second line loan, considered more risky, is now being quoted at 7% and higher. Chrysler's finance arm will be trying to fund an additional $8 billion in loans and rates being quoted are moving higher there also. Another $40 billion in debt will come in the form of asset-backed securities. Reportedly big buyers of these loans in the past have been hedge funds but they are staying on the sidelines at present.
The problem is the sheer amount of debt being floated by the LBO firms. In the table below you will see that the deal total for 2007 has already surpassed the total for all of 2006, which was the all time record high. So far in 2007 the deal value is more than four times the total value in 2004 and three times the deals in 2005. The final total for 2007 is going to staggering. Assuming only 50% of the first half is done in the second half of the year we could be looking at $650 billion for all of 2007. By the end of 2007 we could be looking at $1.35 trillion in deals over the last 4 years. The market is drowning in LBO debt and you have heard many times about the world being awash in liquidity. How much more debt can be sold is anybody's guess. All that debt has got to come back to the market before the LBO firms can make a profit. They have to restructure the companies and then bring them back into the equity market as new IPOs to cash out on their play. That is going to be a lot of IPOs over the next 3-4 years. It also assumes the market will still be friendly to equities and to IPOs in general. Lenders were ready to dole out the cash when this trend began but they may be rethinking it today after the various subprime blowups. They are not related but we could quickly have a round of LBO blowups just as easily. What if the currently booming world economy suddenly burned out? What if Al Qaeda started setting off hundreds of improvised explosive devices (IED) in the U.S. like they are currently doing in Iraq? Don't think it can't happen. What would our markets be doing? What if Peak Oil actually occurs before 2010 as most petroleum engineers believe? Would gasoline rationing and $200 oil crush the global economy? Absolutely and it will eventually happen, it is only a matter of time. Lenders are starting to worry about all the LBO debt they have on the books. New debt is going to see a higher risk premium and stronger guarantees. Those covenant light loans are going to disappear. That could mean a substantial slowing to the LBO craze and that would negatively impact the equity markets. Equities have been climbing higher on a constant reduction in stock for sale. Massive buyouts and massive buybacks have taken more than $2.5 trillion in stock out of the market over the last four years. What if that trend suddenly ended or even worse it reversed to stock coming back into the market? This is what is weighing on lenders this weekend. The fear is growing that the end to the LBO boom is in sight.
Table of Leveraged Buyout Deals
On Friday's Citigroup conference call CFO Gary Crittenden said Citigroup was UNABLE TO SELL DEBT on four deals forcing Citigroup to hold the so-called bridge loans on their balance sheet. Citigroup took a hit to revenue in Q2 because of these loans. He also said Citigroup was likely to be stuck with more deals in Q3 and it "will impact our revenue." Citigroup said it was stuck with so-called equity bridges, in which the bank takes direct equity stakes in companies being bought out with the aim of later selling that stake to other investors. These are typically very risky positions. Citigroup said it was comfortable with its risk at around 5% of its revenue but uncomfortable with taking on future debt of this kind. JP Morgan reported last week they were also setting aside additional funds to cover debt they are having trouble selling. If these financial giants have to eat these equity loans it suggests the market is turning soft very quickly and Citigroup, JP Morgan and others will be far less likely to take any deal coming at them. They will become much more picky and that will slow the overall volume of deals. That will eventually impact the equity markets. The recent Blackstone (BX) and Fortress (FIG) IPOs are down over -25% from their IPO price on worries about the future of the LBO sector.
I believe Citigroup's admission of being unable to sell debt on the morning conference call was a big reason contributing to the market collapse. Citigroup's comments knocked others in the sector into the cellar with GS losing -5.76, MER -2.68, BSC -4.21, LEH -2.14 and MS -2.31. A nearly +$1 billion jump in profits for the quarter kept Citigroup from joining the biggest losers list but it did finish down slightly. The benchmark ABX subprime debt index hit a new record low also weighing on financials. The financial sector is the only S&P sector in the red for the year, down nearly -4%. The disaster at Caterpillar knocked another 60 points off the Dow at the open but that was halved by CAT's rebound before the close. The market did not share in that rebound.
On Tuesday the Dow passed 14,000 intraday but closed -26 points below that level. I attributed the prior week's +450 point rebound to short covering given the record short interest in the S&P and Russell futures at the prior Tuesday's close. Guess what? Last Tuesday's close was an even higher record of short interest with the Dow at 14,000. It appears the shorts forced to cover were ready to pile right back in once 14,000 was reached. The rebound at Wednesday's close and into Thursday's open was another textbook short squeeze but there was no breaking that Dow 14,000 level on Thursday. There were plenty of sellers waiting on that second attempt. At the same time we are seeing a surge of buying in bonds sending yields on the ten-year note to 4.95% and a new two-month low. Bernanke must be having Greenspan nightmares. He talked tough and tried to put the inflation scare into the bond market in his two days of testimony last week and rates went lower rather than higher. Although it seems just like yesterday that we were waiting for the post FOMC announcement the next meeting is almost upon us. The Fed meets again for a one-day meeting on August 7th and I would expect some harsher tones in the statement meant to put the fear of rate hikes back into the market.
All the Fed members are talking low inflation, if you use the core rate, but the cost of food and energy continues to rise. The Clinton administration changed the way the CPI is calculated to produce a lower inflation rate. Using the pre-Clinton CPI inflation is now running about +11%. Which seems closer to correct for your expenses, today's CPI at 2% or the prior calculation at 11%? It probably seems closer to the 11% and that is due in part to the crash of the dollar in value. On Friday the dollar hit a new 10-year low and came within 3 cents of an all time low. With the dollar falling relative to any hard asset like gold, oil or any overseas goods bought with dollars it takes more dollars today to buy the same item you bought last week. Seems to me that is the textbook definition of inflation. The dollar index has fallen -13 cents from its 2005-Q4 high and that means everything bought with a dollar requires roughly 13% more dollars to buy today. For instance a barrel of oil cost roughly $66.50 to buy on Oct-1st 2005. Today that same barrel is $76. Oil's value did not change but the dollar did. $66.50 x 1.13% = $74.58. Funny how that works out almost exactly to today's price. Eventually this real world inflation is going to show up in the Fed numbers and there is going to be a serious impact to the equity markets.
Dollar Index - 5 years
While I am on the subject of oil I am sure everyone noticed the new contract high at $76.13 on Friday. $76 and not a hurricane in sight. $76 and gasoline has fallen from $2.38 on the 10th to $2.07 on Tuesday, a -13% drop. $76 and crude inventory levels are at a decade high. There is nothing new on the geopolitical horizon and despite all time record demand for gasoline of 9,710,000 barrels per day last week the summer driving season is about over. Makes you really wonder about the relationship between the price of oil and the value of the dollar doesn't it. I know, in reality everyone is afraid a hurricane will show soon but if it does not show in the next week or so oil is going down hard. Actually we have already seen $80 a barrel this year for light crude, just not the West Texas Intermediate (WTI) crude that is commonly quoted as the benchmark price. Nigerian Bonny Light has been over $80 since July 9th and Louisiana Light Sweet (LLS) hit $80 late last week. I know the televangelists of oil are predicting as high as $85 before the summer is over but without a hurricane it is going to be tough to hit those levels as long as gasoline continues to fall. In the chart below you can see that crude inventory levels are well in excess of the 5-year average (blue band).
Crude - Five Year Average Chart
Let's not forget our current tie to China. China's GDP was announced last week at +11.9% for Q2 and topping every estimate in the Bloomberg poll. Inflation rose +4.4% and the most since September 2004. This exceeded the central banks target of 3.0% for the 4th consecutive month. Oil imports rose +12% over the same period in 2006. The Shanghai Composite (SSEC) spiked another +3.69% even after its months of already stellar gains. The SSEC is up +95% year-to-date and was up +150% last year. This is the chart in the dictionary that defines irrational exuberance. China reacted quickly to the GDP news and hiked rates another .27% to 6.84% but that minor change is not likely to slow their economy. Let's not forget how quickly our markets reacted to previous drops in the SSEC. If that resistance holds at 4250 and a long overdue correction begins it could spread a bad layer of ugly around the globe.
Shanghai Composite Chart - Weekly
For next week the main focus is going to be earnings with an increased sideline focus on economics later in the week. Ironically even after a disastrous earnings week the estimates for some stocks continue to rise. Apple Inc (AAPL) gained +3.75 on Friday to $143.75 after a Piper Jaffray analyst raised his price target to $205 citing a robust sales forecast for the iPhone for fiscal 2009. 2009? That is looking way down the proverbial road. Unfortunately options are so dang expensive on Apple now the penalty for guessing wrong ahead of earnings would be huge. This is a stock that has every right to crater post earnings but from this side of the event I can see nothing to criticize. My only complaint is that I took profits at $120.
Texas Instruments (reports Monday) was surging into its report but the Intel sell off knocked out the props on TXN and it pulled back to support at $38. It could go either way from here now that the expectations have been dulled slightly. Amazon (Tuesday) also gave back some of its pre-earnings gains last week but is still basking in the glow of its April earnings surprise that produced a +$30 gain over the last three months. That suggests Amazon earnings could be dangerous. Expectations will be even higher this time around because of last quarter's surprise.
Cummins (CMI - Thursday) was expected to strongly beat estimates but the CAT miss may have taken some of the expectations out of CMI. After the +$50 gain over the last quarter I could easily see some serious damage if they don't beat by a mile. Again, CMI options are expensive after the CAT surprise.
Exxon reports on Thursday and they will report massive earnings once again. The key here is that all the good news is definitely priced in with the +$22 gain since March. It would be hard for Exxon to disappoint and even harder to really post an upside surprise. Exxon options are actually cheap because there is no unknown and there are 5.6 billion shares outstanding. Large sudden moves don't happen very often. Because of the potential drop in oil prices I might speculate in some Exxon puts about 90 days out.
Qualcomm (QCOM) reports on Wednesday and this could be a put candidate. QCOM suffered a setback on Thursday when Verizon pulled out of the protest against the import ban on QCOM enabled phones. Verizon signed a deal with Broadcom to pay $6 per Qualcomm phone imported into the U.S. and dropped support of Qualcomm. A court found Qualcomm in violation of several Broadcom patents and imposed an import ban on phones in violation of that patent. Verizon, Sprint and several other carriers would be hurt very badly by this ban and the inability to import phones for the coming holiday season. Qualcomm refuses to settle even though Broadcom offered them the same $6 per phone royalty deal. Qualcomm says the deal would cost them $2 billion a year and refuses to pay. Odds are good Qualcomm will have to say something negative in their earnings guidance. Puts are cheap despite the -$2.50 end of week drop.
NYSE Composite Chart - Daily
Next week is chip and energy week for earnings with dozens of companies in each sector confessing their sins. Oil companies that cannot beat estimates over the last quarter should be banished to the artic to explore for oil. Chip companies are a different story. There are plenty of mixed results expected with some going to crash and burn while others soar. It is knowing who will do which ahead of the event that poses a problem. The SOX was one of the few indexes to post a gain for the week even after Intel spoiled the party. According to most reports PC sales are booming and we already know cell phones and video games are hot as well. The problem is the large number of manufacturers. It is very tough to produce large profits with a dozen of manufacturers all trying to compete in the same market. Broadcom has an inside track here as does Nvidia. The ATI/Intel combination has yet to push Nvidia out of the market and if anything slowed down ATI's ability to move quickly. I have bought a dozen high level Nvidia video cards in the last few months after problems with multiple ATI cards. Nvidia is currently the winner in this sector. They are expanding into extreme high performance gaming products including motherboards and complete PCs along with their marketing partners. They are also releasing extreme performance computing systems for fields like geosciences, molecular biology and medical diagnostics. They are not just video cards any more. Unfortunately there is no earnings date posted and Nvidia has not responded to my emails as of yet. I am expecting their earnings the first week of August. I will keep you posted. I would buy Nvidia on any serious pullback.
So far this earnings cycle about 25% of the S&P has reported with 59% beating estimates, 20% reporting inline and 21% missing estimates. The average earnings growth so far is coming in at about +10.4% on an earnings per share basis but only +4.1% on a total profit basis. Everyone expects those numbers to slide significantly before the cycle is over even with strong earnings from the energy sector. Remember, earnings per share is skewed significantly higher by share buybacks and you can see that difference in those two numbers. Buying back shares makes you look like a big winner while actual profits are just creeping along.
Forgetting earnings gyrations and potential economic minefields next week we are still faced with what appears to be a solid top at Dow 14000, SPX 1555 and Russell 855. The Nasdaq is not showing a clear line of resistance but is showing a critical line of support. Here is the problem we are facing. Short interest was at record highs on Tuesday. Thursday's rebound was stopped cold at 14000. Friday's volume was nearly 7 billion shares and was 6:1 in favor of decliners. After a retest of the historic highs, volume that imbalanced to the downside looks an lot like a top. Of course we had the option expiration to skew the volume and cloud the issue but bear with me here.
Depending on how you compare data August and September are typically the two worst months for the stock market. Since 1950 September has the record for being the worst month for all the major averages. In the shorter term August has been the worst month for the averages for the last 16 years. Together they are the valley of death bull markets must cross. In theory it is the end of summer back to school mentality that causes problems. Traders and investors are trying to cram vacations into the few weeks left for summer. Retail investors are taking money out for those back to school expenses, college tuition and to pay for those vacations. As the third quarter progresses money managers tend to prune portfolios to get rid if under performers and take profits on those that have run ahead of their values. Managers want to stock up on cash for the typical October bottom to capitalize on bargains as the Q4 rally begins. Of course this is a typical scenario as seen over dozens of years. How this year will react is yet to be seen. If you had bailed last August you would have missed out on some very nice gains since the market rallied out of the July dip and never looked back until February of this year. That July dip came on the second week of earnings season, which just happens to be next week. There was no September/October crash and we saw days on end with no selling whatsoever. In 2005 the last week of July was the summer high and the markets hit a low in October just like they were supposed to.
Since we can't see the future we have to react to the little road signs along the way. Once of those road signs was a double top at 14000 last week. Another was the extremely high volume on Friday. Another would be a break of support on the Nasdaq at 2675. Critical Dow support is well below at 13450 so there is plenty of room for profit taking before the Dow is in danger. Retail margin loans hit a new record this week. Short interest on individual stocks hit a new record and that is also a pair of road signs but which way are they pointing?
Nasdaq Chart - 90 min
SPX Chart - Daily
Russell-2000 Chart - Daily
Don't you wish you could see how the professionals are trading so you would know which way to lean? Fortunately to some extent we can. The Commitment of traders report as of July 17th shows us the hands held by the commercial traders, those who trade big dollars, and by individuals and smaller accounts called non-commercials. Typically the commercials are in the right trade and the non-commercials, the little guys, are wrong. It sometimes goes the other way but generally those with billions of dollars at stake are playing a winning hand. In the table below there are plenty of contradictions, enough to make your head spin. The big guys are heavily long the S&P and Russell futures while the little guys are extremely short. In theory that means the S&P/RUT have a better chance of moving higher than lower if the big guys decide to jab the index with a sharp stick. They can do it if they want to simply because of the amount of money they control. Knowing the little guys are extremely short allows the big guys to cause them pain any time they want. A quick buy program when it is not expected and those little guys will be running to cover. However, it is not that simple this week. On the Nasdaq futures the positions are reversed with the commercials on the short side. That would make me think the Nasdaq could be heavy next week but not materially since the S&P/RUT would have to confirm for the Nasdaq to dive. That leaves us with some good information but still lacking in a firm direction for the indexes. It will be interesting to see how this plays out. Technically it suggests another rebound but conditions can change in an instant in the futures market. For the commercials to shift to a short bias in the S&P/RUT would require a huge amount of selling and Friday could have been the beginning. Over 2.2 million S&P contracts traded on Friday. We won't know for sure if they changed sides until the next report is published on July 27th.
Commitment of Traders Report
I added another line to that table and that is crude futures. Note that the little guys are long nearly 2:1 over the shorts while the big guys are nearly even with only a 10% edge to the short side. I would read that as an impending move lower since any additions to the short side on the commercials would come at the expense of the overly long little guys. However, I am biased to an impending top in oil prices so that may not be an arms length analysis.
When I started writing this commentary after the market closed I was bearish.
After several hours of research I have moved back to neutral. I can see all the
road signs pointing to the downside but every dip for months and months has been
bought almost immediately. Logically I would expect some weakness into
August/September but using logic on the market rarely works. The technicals have
not yet broken down even with the high volume. I am afraid of the Citigroup/JP
about not being able to sell debt but that is a big picture item
not a day-to-day problem. It may have hastened Friday's decline but we do not
know if it will carry over into Monday. The expectations for earnings took a
huge hit last week and that may be positive for next week. Lowered expectations
means smaller drops on missed earnings. Whichever way you play these earnings
don't bet the farm on any one position and prepare to exit quickly if your
position goes against you.