This was an ugly week and the bears ruled from start to finish. The last four days saw record volume and it was heavily weighted to the downside. The say bull market corrections are short, sharp and scary and last week definitely fit that description. The same market moving factors remain and none had improved by Friday's close. The housing sector is sinking faster than ever and the LBO party appears to have come to a sudden halt when the liquidity punchbowl ran dry. Buybacks were the only positive force and TrimTabs said 29 were announced on Thursday. That is the most on any single day since 9/11. Companies are taking advantage of the decline to buy their stock back cheaper and it is also common for major companies to announce buybacks in a freefall market in an attempt to stop the damage to their own stock.
Dow Chart - Daily
Nasdaq Chart - Daily
Friday's economic reports were headlined by a stronger than expected GDP for the second quarter. The GDP showed +3.38% growth in Q2 and much stronger than the +0.6% growth in Q1. This should have been market friendly but the post GDP bounce was short lived. The weak housing market knocked -0.5% off the headline number and weaker growth in consumer spending also produced a drag but not enough to keep the headline number from posting a big gain. Residential investment fell -9.3% but that is only half the rate of decline in Q1. Core inflation rose only 1.4% annualized and the lowest since Q2-2003. Corporate profits remained high and the excess inventory problem from prior quarters has passed. This report will be neutral for the Fed when they meet on Aug-7th. It was not strong enough to pressure them to raise rates but it was definitely strong enough to prevent them from cutting rates to help the housing sector.
The other report, which went unnoticed behind the market volatility, was Consumer Sentiment at 90.4. This was a drop of -2 points below the initially reported 92.4. Higher gasoline prices and the continued decline in housing prices were the major depressants. Both present conditions and future expectations saw gains despite the growing negativity in the economic arena.
Next week is a monster week for economics with a packed schedule of important releases. Monday the National Association of Purchasing Management - New York (NAPM-NY) will provide a business update for the New York area. It is probably the least important report of the week and the only report scheduled for Monday. That leaves the market free to concentrate on the leftover negativity from last week. On Tuesday there is a full schedule headed by the Employment Cost Index and the Chicago Purchasing Manager Index (PMI). Both of these reports are headliners with indications for wage inflation and economic conditions.
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On Wednesday the Institute for Supply Management (ISM) Index will give us the national look at economic conditions. The index has rebounded sharply from the January low of 49.3, just under 50 and indicating economic contraction, to 56.0 in June and the highest level since early 2006. The expectations for July are for a flat report with no change from June. New orders and order backlogs were weak in June and economists expect this to carry over into July.
Thursday has Factory Orders and expectations are for a slight -0.5% decline. This would extend the weakness seen in June that saw durable goods fall -2.4%. Weakness in consumer buying is pressuring those durable items. That weakness is related to the weakness in the housing sector. The dramatic slowdown in housing means fewer dishwashers, water heaters and other durable household goods are purchased. How much the continued housing decline has impacted this report will be a matter of concern for analysts.
The biggest report for the week will be the July Employment report next Friday. Officially the estimate for new jobs is flat with last month with 135,000 new jobs created. The normal whisper number chatter in the market has been strangely quiet this time around. We have been seeing a strong pattern of upward revisions but even that speculation has been silent. This suggests there is a fear of a dramatic decline in employment but nobody wants to be the scapegoat that goes public first and attracts all the criticism. A solid drop in new job creation would be about the only thing that would push the Fed to cut rates next week.
Nearly 400 of the S&P-500 have already reported earnings with another 99 scheduled for next week along with four Dow components. So far earnings growth for the S&P has been just over +5.7% and higher than the official 4.1% estimates we were seeing just before the earnings cycle started. There have been some high profile misses and some large upside surprises. Other than some amazing gains on the individual stocks beating estimates the impact of the earnings cycle has been negative. Exxon was the biggest negative influence last week when they missed estimates and fell nearly -10% over the following two days to close at $85.60 on Friday. Exxon posted horrible earnings of ONLY $10.26 billion for the quarter and well below the $10.36 billion in the comparison quarter. Of course I am kidding about the giant earnings miss, still the 4th largest quarterly profit ever for a U.S. company, but the way the stock was pummeled you would have thought they had missed it by 50%. Their revenue of $97.6 billion for the quarter beat estimates but nobody noticed. Analysts criticized them for falling production but Exxon has committed to spending $20 billion a year for the next three years on 20 new projects to increase production. It was not that Exxon's earnings were bad it was the market that was bad and by failing to surprise to the upside Exxon shareholders paid the price. That same earnings story was repeated dozens of times throughout the week with the same result.
Next week the big names on the schedule include Kraft, Procter Gamble, Eastman Kodak and Mastercard along with some leading energy stocks including VLO, MRO and EOG. Add in a few banks, drugs, chips and techs and there is something for everyone. I don't expect everyone to be paying attention given the market hysteria but for those traders focused on earnings there are around 1,033 companies reporting next week.
This was a major week for the markets and the bears were the clear winners. The sell off knocked -585 points off the Dow, -125 from the Nasdaq and -75 from the S&P. The broader indexes saw even larger losses. The NYSE composite lost -564 points with the Wilshire 5000 lost a whopping -795 points. The biggest loser of the major indexes was the Russell-2000 with -58 points and that equates to -7.1% for the week. These losses produced some serious indigestion for traders and conditions were still worsening at Friday's close.
The market internals for the week set volume records that may stand for quite a while. Tuesday's volume was a record, followed by another record on Wednesday and then a massive +3 billion share bump for yet another record on Thursday. Think about that! Three billion shares more than the prior record just a day earlier. Unfortunately the increase in volume was entirely to the downside with Thursday's declining volume more than 10 times the advancing volume. While Thursday's volume imbalance was off the charts the declining volume was well ahead all week. If you add the days together as I have done in the table below there were more than 33 billion shares of down volume for the week. This compares to an average week of about 10 billion. Friday was also a record volume day coming in second on the all time list.
Market Internals Table
Obviously there are two key questions. What caused it and when will it be over? The cause of the sudden decline was exactly what I warned about last week. It was the perceived (real or imagined) evaporation of liquidity in both the public and private markets. The subprime meltdown has turned into a meltup and now prime loans are beginning to default in large numbers according to Countrywide Financial (CFC). Because of this there were several reports of "no bids" for mortgage debt of any type. If the housing problem has gotten so bad that even prime loans are defaulting and about to add to the foreclosure problem and further depressing prices than banks do not want to own the mortgages at any price. Reportedly mortgage portfolios and structured loan products are flooding the secondary market as banks already holding the paper try to offload the problem to somebody else. Over the last decade creative bankers derived a way to turn subprime debt into AAA credits by creatively packaging the loans into heavily leveraged products. Ratings agencies S&P and Moody's blessed these products with an investment grade rating and everybody profited. None of these products had ever defaulted so the investment history was 100% golden.
When the housing boom went bust and these products started imploding it became a game of hot potato with quick thinking banks swapping paper as fast as they could unload it to buyers less educated or more risk aware then themselves. As the situation worsened and lenders started declaring bankruptcy, over 60 at last count, nobody wanted to be caught holding the paper when the music stopped. Unfortunately bids dried up and the paper stopped moving. Everyone from Bernanke and Paulson down to the lowest civil servant in the administration claims the damage is contained and it will not spread any further. In reality it has already spread in the form of a credit crunch on American consumers. There are many stories making the rounds about banks turning away borrowers or asking astronomical rates making loans unaffordable. Those shopping for loans are giving up and home sales have slowed to near zero. According to one survey over the last quarter new household creation has plunged by more than 70%. That means new first time buyers are being locked out of the market by factors beyond their control. Prime buyers who are lucky enough to get loans can't move because nobody can finance the house they are selling. Home prices are falling faster than any time since the great depression. Bear Stearns added fuel to the flames on Thursday when they reported they seized the assets of one of their troubled hedge funds when they could not meet their margin calls. Bear just loaned the firm $1.5 billion a couple weeks ago and the fund had already fallen further into default. Bear said it would put the assets on their books and hold them until they could be repackaged and resold after a period of calm de-leveraging. I thought they de-leveraged the fund a couple weeks ago with that $1.5B investment. Evidently that double-edged sword called leverage is still coming back to haunt them. This kind of news just makes it harder for the rest of the sector to conduct business as usual.
That may sound like it is just a mortgage problem. Unfortunately it may have started out as a mortgage problem but it has contaminated the corporate credit market. Lenders finding out that their investment grade paper is no longer investment grade and in many cases there are no takeout bids are finding themselves suddenly a lot more cautious in what paper they are willing to buy. It is though they are relating the subprime credit problem in mortgages to what could be considered subprime corporate paper. While Blackstone, KKR and Fortress may not be considered subprime credits the deals they structure do contain risk. Many times a lot of risk for the buyers of the debt generated in these leveraged buyouts. Buyers have pulled back from the marketplace until the smoke clears. They do not want to be left with "hung paper" in banker terminology. That means the money they loaned as a bridge loan to get the deal closed can't be sold off to somebody else leaving the bridge loan to mature on the books of the originating bank. Typically a bank like Citigroup would provide a loan commitment to the deal originator like Blackstone. Citigroup would then shop the deal and sell it off to another bank that did not have the deal generating capacity of Citigroup but had money to loan. Citigroup would take a fee for placing the debt. Those second party debt buyers have gone into seclusion just as subprime mortgage buyers. The major banks are finding it very hard to place the deal debt and many deals are starting to crumble around the edges. In an effort to calm nerves on Friday Citigroup said their total exposure to hung deals was less than 5% of revenue. That gave them about a 30 min reprieve from the selling before moving down again. $12 billion of the Chrysler deal failed to find a home and the deal had to be restructured with Citigroup agreeing to hold the debt until later in the year when they hope to place it once the credit crunch eases. There are reportedly more than 30 deals that have already been postponed and we are hearing about more every day. Cadbury Schwepp (CSD) announced on Friday that they were postponing a sale of their U.S. beverage unit due to unfavorable financing conditions. The rumors on the floor late Friday suggested there were several other deals on the verge of collapse. Bloomberg reported on Friday that $32 billion in debt sales were cancelled or restructured last week. According to various sources there are between $325 billion and $440 billion of deals in the pipeline to be funded. With buyers closing the door on new debt until the smoke clears it could be months before the market returns to normal.
Why is this a big deal? One commentator offered a perfect analogy. If you worked in a gunpowder factory and suddenly smelled smoke would you keep working? I seriously doubt it. You and everybody around you would run for the hills as fast as possible and you probably would not venture back into the factory until well after the all clear sounded. This is exactly the same scenario in the banking sector. There is smoke everywhere and it is so thick they can't tell fact from fiction. The only solution is to run to the safety of your vault until the smoke clears. Some analysts are saying now they don't expect any major new LBO deals until after Labor Day at the earliest. LBO firms can't get loan commitments and without commitments they can't commit to new deals. Why Labor Day is the magic date on the calendar is unclear. What the market needs is to see some major deals get funded like the Chrysler deal on its scheduled August 3rd closing date. Seeing deals getting done will relieve tensions in the sector. Seeing more deals blow up will increase the anxiety and lengthen the time needed for the sector to cool.
Another problem is the unwinding of the Yen carry trade that Linda described earlier last week. Hedge funds have been borrowing Yen at interest rates next to zero and using the proceeds to buy higher performing equities and things like mortgage loans and LBO debt. Now that these debt instruments are coming unwound, and many without a bid, those hedge funds are scrambling to sell other assets to cover the Yen loans. There are other currencies involved as well but the Yen is the predominate one due to its low interest rate. If you can't sell mortgage debt and you can't sell deal debt you are stuck selling other assets to raise cash and that is where equities enter the picture.
Borrowing Yen to invest in the stock market was the greatest free lunch ever devised. With base rates of .25% to .50% over the last decade Japan has been the banker of choice for the 9,000 or so hedge funds needing deep pockets. An impending rate hike in August might take that base rate to a whopping 0.75%. You would think that would not matter much in the greater scheme of things. However as I have been reporting the value of the dollar has been dropping almost daily for months AND these same hedge funds were able to leverage those loans to 10-20 times their actual value. That is ok when you are buying dollars with Yen for investment purposes but when you need to switch back to Yen to cover your highly leveraged loans it now takes a lot more dollars to buy the same amount of yen. The dollar has declined in value by roughly 14% since Nov-2005 and 4% since mid June and has been in virtual free fall. That -4% drop over the last month is like an additional 4% interest surcharge on your loan. If you had the loan since Nov-2005 that is an additional 14% surcharge to payoff your loan. For many hedge funds the pain threshold was broken with that last 4% drop since June 18th. As long as the stock market was climbing they could do the daily math and hold on. Once the market topped out and the dollar continued to fall the house of cards began to collapse. Since they could not cash out their various CDO, MBS and LBO debt they had to turn to the stock market to raise cash. The Bank of International Settlements reported in March that more than $370 trillion was outstanding in over-the-counter derivatives with much of that fed from the Yen carry trade. There are more than $262 trillion in interest-rate derivatives and $38 trillion in currency derivatives. Others believe this is just a tip of the iceberg and Ron Insana reported on Friday that the total derivatives were probably more than $750 trillion with most of it in unregulated OTC form. How much of that is ultimately based on some form of Yen carry is unknown. Just 1% would be earthshaking if it needed to be unraveled quickly.
The subprime contagion, the credit crunch and the unraveling of the Yen carry trade were not the only reasons the stock market imploded but they definitely hastened the decline. For the last two weeks I have reported that short interest and margin loans have been at record levels. Well you can now make that three weeks because those vehicles hit new high levels again last Tuesday. The shorts were finally rewarded at the expense of those leveraged to the hilt with margin loans. Given the strong dump in the markets 15 minutes before the close and in the futures for 15 min after the close, Monday is going to be another bad day for those still on margin. On Thursday alone the stocks in the Dow lost more than $105 billion in market cap. I can't even imagine the market cap loss in the S&P or Nasdaq.
The massive selling knocked the S&P back to 1460 for a weekly drop of -4.9%. That is the biggest weekly drop since September 2002. It was a mini correction in just one week. If you go back and study the charts you will find a -5% correction on average about twice a year. Remember bull market corrections are short, sharp and scary. It is just our luck to have two such memorable events in the last five months. In February the S&P plunged -88 points in seven days compared to the -96 points (-6.1%) lost since the July 19th high.
In theory the correction or at least the scary part should be over. The first few days are the hardest with the last few days a painful hunt for a bottom and then a retest of that bottom before moving higher. Remember I said "in theory." The calendar may be working against us next week. The decline in the various debt indexes has been brutal and many debt holders will have to "mark to market" as opposed to "mark to model" when valuing their portfolios for month end on Tuesday. Many have covenant restrictions in their working capital loans that require a certain debt to equity ratio and those ratios may be in danger given the violent repricing this debt has undergone. Some of these debt instruments are now being quoted at 30 cents on the dollar. How do you raise your debt to equity ratio? By selling assets to raise cash and reducing your leverage. Those assets are equities and I believe the various Friday sell programs including the massive sell program at the close was designed to raise cash before month end. Since the month end is Tuesday stocks had to be sold on Friday to clear before month end.
I said the calendar may be working against us but in reality the worst may be over except for the margin selling on Monday. We should open down on Monday due to the very heavy selling in the futures after the close. The S&P futures lost almost -10 points after the cash market close. That selling was also evident in the Nasdaq and Russell futures. This suggests Monday should open lower and that will cause even more margin selling. Once that dump is over I think we may be poised for a rebound but I doubt it will be straight up. I think damage has been done to investor sentiment and this is not normally the spot on the calendar known for bullish events. August is not normally kind to investors but maybe we have already had our bout of summer selling and it will be more of bottom testing rather than further implosions. It really depends on the hedge funds, credit news, month end, the Yen carry trade, earnings, economics and fear of the FOMC meeting the flowing week. Those are plenty of reasons for the market to remain indecisive.
Dow Chart - 180 min
On Friday the Dow bounced at the open into positive territory at 13517, fell over -210 points to 13303, rebounded +134 points to 13437 and then collapsed -170 points in the last hour to close at 13265 and a loss of -208 for the day. To say volatility had returned would be an extreme understatement. The VIX closed at a new 52-week high and well above levels seen in the March sell off. The closing level could not have been any closer to critical support if we had scripted it in advance. Twice in June we tested the 13250-260 level and both times it held. That makes this critical support that must hold again or we really will see a new round of computer generated sell programs. A rebound from here would be the perfect mini-correction event. A failure here would suggest a full -10% correction that would target 12600 but probably fail with support holding at the 200-day average at 12750. I don't want to test either of those levels but it would be a great buying opportunity.
NDX Chart - Daily
Nasdaq Composite - 180 min
The Nasdaq is in much better shape if you use the NDX as your guide. The NDX has only retreated to its uptrend support and has yet to break any serious technical level. The Nasdaq composite chart is a little more congested with the potential for a drop to 2525 from its current 2564 level. If the NDX holds the Compx will never make that trip but this is the current risk. The Semiconductor index gave up -6.4% for the week despite strong earnings from several chip companies. It has reached initial support at 495-500 and should resist further declines.
The chart of the S&P-500 is nearly as ugly as the Russell. The S&P collapsed below the 30, 50 and 100-day averages and is nearing the 200-day at 1448. Friday's halt at 1458 is almost exactly on critical support from February's high at 1460. There is no room for error here and the S&P needs to hold its closing level on Monday or the sell programs will kick in again. A move below the 200-day at 1448 would trigger major sell signals in many fund families. The 200-day average on the S&P is probably the most followed buy/sell indicator. The S&P signaled a buy when it crossed above the 200-day at 1271 on August 15th 2006. That resulted in a +22% gain to the market recent highs at 1555.
SPX Chart - 180 Min
The Russell-2000 is by far the scariest chart. It is also the one that should show the greatest decline if this is a normal August sell off. Small caps are normally sold into the summer doldrums and then bought again in October for the year-end rally. The Russell struggled at 855 since June 1st with repeated failures to break that level. The last test was July 17th and with that failure the funds threw in the towel and pulled the plug on small caps. That was followed by an eight-day drop of -9% to close on Friday at 778. All the gains for the year have been erased and the Russell is in danger of an even greater drop. It is already well below its 200-day average at 804. There are three levels of weak support at 775, 760 and 750 before facing another free fall event to 670. I don't expect the 750-760 support levels to be broken but it closed at a new 4-month low on Friday on very strong volume. It was not a pretty picture and definitely not one that has me rushing to buy the dip.
Russell 2000 Chart - Daily
Russell-2000 Chart - 180 min
I heard so many analyst/traders calling for a continued drop next week that I
almost believe it is a contrarian signal. I would like to think any dip on
Monday morning would be a buying opportunity but until we see the signs of
selling abate we need to watch from the sidelines. The ferocity of the selling
last week amazed me. Triple digit moves with no letup and extreme imbalances on
the internals. If ever there was a picture of capitulation it was Thursday but
then Friday came right
back and was slammed even lower. There are forces at work
behind the scenes that I attempted to describe above and we have no control over
when they will stop. I would spend the weekend planning your buys but wait to
pull the trigger until you see the selling diminish. It is better to be late to
the party and join it in progress than come early and be put to work cleaning
house. If the Dow does break 13250 and S&P 1460 on volume I would jump on for
the ride to lower levels. Downside
breaks are normally fast and furious as we
saw last week. Under 13250/1460 it could be a long drop. Prepare for both
directions and trade what the market gives us.