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Market Wrap

No Lipstick For This Pig

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It does not matter how much lipstick you apply to last week's market crash to dress it up. The result is still an ugly market. All the bulls have scattered and the bears are firmly in control and enjoying the barbeque. It was a perfect storm that stampeded the bulls with negative press releases pounding their backsides like summer hail. Earnings misses, weak guidance, write downs, questionable economics and weak Fed statements all worked together to sour market sentiment.

Wilshire 5000 Total Market Index Chart - Daily

There were no earth shaking economics out on Friday with the biggest news a sharp drop in Consumer Sentiment. The headline fell to 75.0 and the lowest level since Oct-2005. It was the second lowest reading since the 1990s. To say that consumer sentiment has turned sour would be an understatement. The problem with falling sentiment is its impact on GDP. Over 79% of our GDP is derived from consumer purchases. If consumer wallets tighten as they did post 9/11 the economy will drop like a rock. The internal components fell sharply with the biggest decline in the present conditions component with a drop of -6.6 points. With oil prices at record highs and well publicized by the press there has got to be a lot of apprehension about heating and transportation costs. Heating oil is already at record levels and gasoline can't be far behind. The average price of unleaded rose +10 cents this week to $3.10 but with oil at $96 the real price of gas should be much closer to $4. A dollar increase in gasoline prices represents real pain for most Americans. Most consumers are just finding out they are locked out of borrowing against their shrinking home equity. Not having that home equity ATM available will shrink the holiday purchases and cancel many home improvements, auto upgrades and even college tuition. The Michigan Consumer Sentiment survey focuses more on consumer finances rather than economics and the equity markets. As such it is the leading indicator for consumer stress.

Consumer Sentiment Table

Consumer Sentiment Chart

Friday's other economic reports included Import and Export Prices and International Trade. Import Prices spiked +1.8% in October but most of that was directly attributable to the +6.9% rise in crude over that period. International Trade was basically flat at -$56.5 billion in September compared to -$56.8 billion in August. This is a trailing number and has no impact on the markets.

Next week we will get the two major inflation reports, the Producer Price Index (PPI) and the Consumer Price Index (CPI). These reports will show how much inflation due to record oil prices has made its way into manufacturing costs and finally into consumer prices. The estimates are for a slower rise in prices in the PPI to only 0.3% growth from 1.1% rise in September. Personally I think this is wishful thinking but they did not ask me. I can't imagine that crude prices haven't caused another strong spike in manufacturing costs. However, the key is how much of that cost the producers are passing along to the retailers. If business is slow they may elect to eat some of the costs and keep prices for their products artificially lower. The CEO of DOW said on CNBC this week that they are using about one million barrels of oil or oil equivalent per day in their manufacturing processes. That annual crude cost has risen to $22 billion in 2007. They have to pass those costs along in their products.

The CPI rose +0.3% in September and I have a hard time believing we are not going to see another 0.3% rise or even higher. Fortunately some consumers will not have to pay those higher food and energy costs because the government does not take food and energy into account when calculating their "core" rate of inflation. As long as you don't eat, heat or drive your rate of inflation will be very low. These reports have a good chance of roiling the markets on Tuesday and Wednesday.

The Philly Fed survey is the next material report on Thursday and will show how economic conditions have changed in the Philadelphia region. This report has a strong correlation with the national ISM and is seen as an interim look at the next ISM, which is not due out until Dec 3rd.

EEconomic Calendar

The Bernanke testimony last week did not help the market. His sometimes-stumbling answers suggested he was either unsure of how to form his answers or trying to create his own form of Greenspeak to confuse the committee members. It was clear that inflation was still the "official" worry but it was also clear that the problems in the financial sector were growing again. This prompted a rise in the chance of an unusual December rate cut from 80% before the testimony to 115% when it was over. The next FOMC meeting is on Dec-11th, an even 30 days from today. There will be a lot of water flow under the economic bridge by then so any rate speculation today is worthless.

This was an ugly week in the markets and my "all the bad news is priced in" bullish theory from last weekend is deader than a bull in a slaughterhouse. The digital ink was barely dry on last Sunday's newsletter before Citigroup said they could see as much as another $10 billion in write-downs. The positive news that CEO Charles Prince abdicated the throne at Citi was overshadowed by the news of massive additional losses. That killed the entire finance sector on the more than one cockroach idea. If Citi was going to take another $10 billion hit only a few days after announcing the first write-down then who else was going to come back to the market with a second or even third confession? Turns out those fears were not baseless. Morgan Stanley (MS) was quick to follow suit with news it was going to take nearly $3 billion in subprime losses. That confession prompted even more financial weakness and turns out it was also justified.


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Wachovia (WB) quickly jumped into the news with a $1.1 billion charge hoping that their minor charge compared to some of those already announced and still rumored would be ignored. AIG also disclosed earnings would be damaged by subprime losses. On Friday, just as the financials were beginning to rebound from the week's events JP Morgan announced it would be taking undisclosed additional losses on its CDO and LBO portfolios. They have $6.8 billion in unsold CDO positions and $40.6B in leveraged loans and unfounded commitments. They will not write down all of it but you can bet the number will be large. They also expect to lose up to $270 million per quarter over the next several quarters on their home equity portfolio due to defaults and foreclosures. JP Morgan said that because of declining market and economic forces their "loan losses may keep rising." Adding to the negative news on Friday was an announcement from Bank America (BAC) that "continued market dislocations," including CDO mortgage securities it owns, will adversely impact Q4 results.

Also on Friday Capital One (COF) warned that its charge off rate on U.S. cards rose to 5.11% in October compared to 4.13% for all of Q3. They said the default rate, cards over 30 days past due, rose to 4.75%. COF just raised their forecast for credit losses on Tuesday. The conditions are changing much faster than expected according to Credit Suisse. There were rumors all day Friday that Barclays (BCS) would announce a $10B write-down. The rumors were so strong that the CEO had to make an announcement denying it. Even untrue the rumor had a lot to do with the negative market sentiment.

After the close E*Trade (ETFC) withdrew its earnings guidance for 2007 citing significant pending write-downs on its fixed income holdings. E*Trade is holding $3 billion in asset backed securities and $450 million of CDOs. E*Trade said in a regulatory filing on Friday that its portfolio of the highest possible credit rated debt had now been downgraded to below investment grade and would force a significant write-down of its assets. In September ETFC slashed its outlook and said it was getting out of the mortgage business. In October ETFC wrote down $200 million in mortgage-backed securities and slashed its earnings guidance to 75-90 cents. On Friday they said they were removing that guidance and investors should not expect those earnings to be achieved. ETFC fell -15% in after hours trading.

Table of Announced Charges

There are many indications the corporate credit market is locking up again. With the potential for tens of billions more in write-downs nobody wants to buy paper or loan money. The August debt wreck is returning just as a new tech wreck has wiped out the last bullish sector. The mortgage market has almost completely locked up with 79% of loans being declined for various reasons and almost no home purchases actually being funded. Funded loans have fallen nearly 80% from October 2006 levels.

The financial stocks were trying to put in a bottom until Wednesday's confessional series knocked the floor from under the sector. It was not enough that the financials fell off the cliff again but GM had to tank the market with its $39 billion loss for Q3. The non-cash loss was mainly related to accumulated tax credits but that did not help GM stock or market sentiment. Just as announcements of big buyouts and acquisitions gives the market a bullish boost the announcement of major losses rekindles fear in the hearts of bulls and emboldens the bears. There was a lot of hope destroyed last week and the bears must be feeling as indestructible as Superman.

I have been telling everyone since the tech rebound began in September that fund managers were storing their money in big cap techs where it could be easily withdrawn in case the economy took a turn for the worse. I cautioned for the last week that the Russell was not following the techs higher and that meant fund managers had no conviction about the market rally. Last week I mentioned that Cisco had the potential to push the markets over resistance as long as John Chambers continued his "best business conditions" mantra when they discussed guidance. Cisco turned out to be the Achilles heel for the tech sector. Earnings rose +37% but that tidbit of information was forgotten when the guidance comments hit the wires. Orders from large U.S. corporations were down -20% over the comparison quarter. Tough to say "best business conditions" when the U.S. is spiraling downward in tech orders. U.S. service providers spending makes up 25% of Cisco's earnings and that order growth pulled back from low 20% range to high teens. Analysts said that was a bigger problem than the slowdown in enterprise spending. Over the last two days since reporting earnings Cisco stock has lost more than 16% and over $30 billion in market cap. Bernanke accelerated the tech sell off when he said on Wednesday that the Fed saw growth slowing in Q4 and remaining sluggish through the first part of next year. Investors heard "sharp drop in orders" from Cisco and slowing growth for 2-3 quarters from Bernanke and put 2+2 together and got "sell" as the answer.

Those big cap techs deflated faster than a popped balloon at a birthday party. IBM lost 12% from the week's highs but it was the earnings contrast that mattered. IBM also reported better than expected earnings back on Oct-16th but saw weakness in both hardware and software orders. Trading at $120 before their earnings they only lost $5 on the news and had been trading sideways at $115 for the last three weeks. When Cisco reported the same drop in hardware orders the bottom fell out. IBM lost nearly $15 for the week on the Cisco news. The point here is that Cisco is seen as a leading edge provider. Companies can't build out data centers and add lots of computing power without Cisco network switches to connect it all together. Those networks are planned well in advance and are put in place before the banks of servers that will eventually run on them. It could take years to fully populate the server farms but the Cisco gear has to be in place first. If Cisco is seeing a sharp drop in U.S. orders then everyone else will see a corresponding drop for new equipment. You may remember SunMicro (JAVA) reported earnings on Monday that disappointed due to sluggish server sales. Sun's server unit growth has been negative for three consecutive quarters. That was largely seen as a SunMicro specific problem until you combine it with the same comments from other vendors. Add all the puzzle pieces together, IBM, Cisco, SunMicro and others and you get an ugly forecast for tech spending and economic growth in North America. That picture did not become really clear until the Cisco guidance connected all the pieces together. You should notice in the table below that the stocks with the largest recent gains were also the ones with the biggest losses. Fund managers finally saw the picture and took their funds out of what had been seen as a safe deposit box up until last week. The big cap Nasdaq-100 or NDX gave up -8.1% for the week.

Big Cap Tech Losses Last Week

NDX Chart - 90 min

Also causing market stress and confirming the sharp drop in consumer confidence was a terrible Chain Store Sales report on Thursday. It was the worst October sales since 1995. Warmer weather was blamed but the weather is always blamed for any disruptions. Since furniture stores were the biggest losers with a -4.4% drop that tells me that it was not entirely a warm weather problem. 67% of the chains reporting missed sales estimates. Wholesale clubs, SAMS and Costco, reported a 5.8% jump in sales but it was mostly in gasoline sales as consumers hunted for the cheapest gas possible. The extra volume and the nearly 35-cent per gallon jump in gas prices during the month produced the sharp jump in wholesale club sales. It was not clothes, napkins, monster bottles of ketchup or cheap electronics powering those gains.

S&P Retail Index Chart - Daily

Dow Transport Index

The Transportation Index collapsed on high oil prices and fears of lower shipments over the holiday season. UBS cut AMR to a sell saying the 30% increase in fuel costs could not be absorbed by the small rise in ticket prices. A survey of business travel plans showed that large companies were cutting back heavily on travel with plans for even more cutbacks ahead. As oil prices continue to rise over the coming years the era of video conferencing is finally going to arrive. You may have seen the Cisco videophones in dozens of movies over the last year as Cisco tries to imprint the video phone/conference image on the civilian population. Hewlett Packard is also pushing their videoconference rooms where conferees sit on one side of a large conference table with the other side a video wall giving the appearance of everyone else at the other side of the table. I have seen one of these setups and it is very nice. It is a lot cheaper than flying five people across the country for a group meeting. I suspect in the not too distant future nearly every mid to upper scale home office will have a videoconference setup other than a videophone. A friend moved across the country and his valued secretary of many years refused to move due to family. Instead of losing her he created an office in her home and paid to wall mount a 52 inch LCD TV and camera in her home office and an identical arrangement in his office. Now thanks to broadband Internet costing only a couple hundred dollars a month they "work" in the same office all day long despite being thousands of miles apart.

Another evidence of cooling consumer spending even at very high levels was the failure of the Sotheby's art auction. Paintings by Van Gogh, Picasso, Renoir and Gauguin failed to garner even the minimum bid. The sale was expected to bring in $400-$557 million but instead found bids on only $269 million in paintings. Sotheby's filed a notice with the SEC on Friday saying they lost $14.6 million in the auction because they have to guarantee a certain price for some paintings to secure them for the auction. Auctions attract a better crowd if they have a lot of high value and hard to get art to draw in the collectors. The auction house secures the key pieces by guaranteeing a certain minimum bid. 26% of the paintings did not even get a bid and bidding on those that did sell was lackluster according to JMP Securities analyst Kristine Koerber. A Bank of America analyst Dana Cohen said this was clearly evidence of the credit crunch and mortgage market playing out in America. She said the various data points they track are suddenly showing heightened risk of consumer weakness. Sotheby's (BID) fell -35% to $33 after the auction.

You would think with crude oil still over $96 that oil stocks would be strong. That is not the case with stocks like Exxon, the largest U.S. oil stock, down -2.57 on Friday. Refiners were still declining even though the retail price of gasoline had risen to $3.10 by Friday. The price of oil should actually have been higher than it was on Friday. The North Sea is experiencing a once a decade type of storm and there are some huge crude flows being halted. Statoil shut in 320,000 bpd, Conoco 140,000 bpd and BP 80,000. They only expect the impact to be 5-days or less but that is as lot of oil out of the market. OPEC is meeting next weekend but there are no production discussions on the schedule. The OPEC president said any changes in output would not be discussed again until the December meeting. That suggests there will be no output changes until January at the earliest. Venezuela tried to get them to discuss using a basket of currencies for payment instead of dollars but OPEC officials said it was not on the schedule. Iran and Venezuela have been trying to switch payment to some other currency than dollars more as a irritant against the U.S. than a real change in the process. With the dollar at 40-year lows that kind of discussion becomes even more relative as a real way to increase income. With the dollar shrinking in value every day the value they receive for every barrel is also shrinking. Crude options expire on Tuesday and the December crude futures expire on Friday. To say "expect volatility in crude next week" would be an understatement.

Next week is also regular option expiration and the volatility we saw last week could have been in part to those expiring options positions being rolled forward or just closed instead. One major options analyst said there was a good chance the holders of the S&P options would try to move prices higher before Friday morning's expiration and then dump the index again on Friday. With earnings basically over and a 3% to 8% drop in the various indexes over the last week there are going to be a lot of options trading next week and $billions in calls expiring worthless.

In the market internals table below it would appear that we had a capitulation day on Wednesday with volume 10:1 in favor of decliners. Unfortunately the selling continued on Thursday with the end of day rally sold hard at the open on Friday. The volume does not show it at 3:1 declining on Friday but the actual index losses were much worse than the internals. Note there were only 79 new highs on Friday and when you look at the charts all the indexes closed at the lows. Normally you would have an end of day short covering spike on the Friday of a losing week. Instead we had a strong end of day crush of selling. That was prompted by the late afternoon news of the new JP Morgan write-downs and rumors of several others. It was an ugly finish to an ugly week.

Market Internals Snapshot

Dow Chart - 5 min

The Dow was led lower on Friday by IBM, MMM, XOM, BA, CAT and GM. The big losers offset gains in AIG and MRK and losses accelerated into the close. In the two charts below I have highlighted the various major support levels for the Dow and they are not pretty. Friday's close was right at major support at 13000 and I would like to think the damage was over and we will rebound from here but nothing in the analysis supports this possibility other than a possible oversold bounce or option expiration games. If the Dow breaks 13000 it could get really ugly very quickly.

Dow Chart - Weekly

Dow Chart With Averages - Daily

The biggest challenge for the Dow and several other indexes is the violation of the 200-day average. For the Dow it is 13218 and Friday's close was 13042. There is no ambiguity there. It is definitely broken and that suggests there could be a lot more fund selling next week. There is no klaxon that will be blaring when traders walk in on Monday morning with the head trader yelling "sell, sell, sell" like the captain of a submarine yelling dive, dive. It is however a strong indicator funds do watch. If the market somehow rebounds back above that level next week then the tensions will ease and traders back away from the sell button. If it appears we are going to break 13000 to the downside I believe we could easily see a lot of funds lighten up into year-end. They do not want to lose their profits and their bonuses by holding tight with white knuckles and try to hope their positions back into the green. It will be a case of simple self-preservation. Take profits and wait until 2008 to make a new investment decision. A fund manager long techs since January would have been up +25% or so at last week's highs. They gave back 8% or one-third of their profits in only three days. Do you think that has caused more than one Maalox moment this weekend? I would bet on it.

The Dow, S&P and Wilshire 5000 have all violated the 200-day average. The Russell has been fighting it for two months and finally gave up on Nov-1st and has seen nothing but selling since then. The Nasdaq and NDX are still well above the 200 with the NDX resting on the 100-day at Friday's close. The 100-day has not been critical support but more or less a warning track that the 200 was just ahead. There is no reason to expect the NDX-100 to hold next week based on the history for the last year. The 200-day is historically considered strong support for tech stocks. The last time it was broken other than the single day dip in August was May of 2006 and the NDX spent four months trying to recover before moving back above the average. Again, it is not an immediate sell signal and the average can remain in play for weeks just as long as a major break does not occur. The Nasdaq Composite is less precise and can wander all around the 200 without any material damage.

Nasdaq Composite Chart - Daily

NYSE Composite Chart - Daily

S&P-500 Chart - Daily

The NYSE Composite touched the 200-day on Friday at 9683 but managed to hold the high ground. The NYSE Composite does not have a strong track record of respecting the 200 but it does seem to acknowledge it. In reality it is millions of traders watching individual stocks that force any index to respect support. It is not a group of fund traders waiting for any specific index other than the S&P-500 to decide to sell or hold. The NYSE may be showing less selling than the other indexes because of the diverse nature of the stocks on the NYSE. I would like to attribute some bullish sentiment to the market from the strength in the NYSE but that does not work this week.

Last week I told you I was bullish and to buy the dips above 13500 and Nasdaq 2780. That lasted until about 11:AM on Wednesday when the bottom fell out due to GM's monster loss and new revelations on loan losses. In theory everyone would have switched to a bearish bias by noon on Wednesday. Unfortunately, theory never works in real life unless it is being used against you. This week is going to start out with a bearish bias and I can't think of any reason today to switch back to bullish unless there was a sudden and miraculous turn around in the markets that demanded to be bought. I can't conceive of that possibility today. We are at support on the Dow but there are simply too many negative economic factors to just assume traders will buy the dip. With the credit markets locked up again and daily confessions of new loan losses it is not a buying opportunity.

The exception here could be a trading opportunity. Remember, this is expiration week and those funds long S&P options may try to game the index as the week progresses. That game ends at Thursday's close. Unfortunately I am not clairvoyant enough to see even a glimmer of that trade in my crystal ball. With negativity this strong it would take some monster buy programs to push the S&P back into a positive trend. This is going to be one of those weeks where we just follow the intraday trend and be fully aware that trend can change several times a day as the VIX approaches 30 again. About the only thing I can promise you for next week is at least one attempt at an oversold bounce and increased volatility as options expire. If you are trading energy stocks remember crude options expire on Tuesday and futures expire on Friday. Crude inventories will be reported on Thursday instead of Wednesday due to the Veterans Day holiday on Monday. If inventories actually show a build this week that last day of trading on the December contract could be extremely volatile.

I said last Sunday that the last week would be crucial to year-end market direction. I believe that again for next week. What happens next week will determine if it was just a normal bout of post earnings profit taking accelerated by news events or the beginning of a new trend. This week could clarify that question. This is not the week to be bold in the market regardless of what you are buying. Be patient and let's see if Dow 13000 will hold and I will update my views on Tuesday evening.

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