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Market Wrap

Sell In May?

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The major indexes posted their first weekly loss in four weeks on mixed news from companies like AIG and Citigroup. Just when it appeared the markets were breaking out the reactions to major news events changed. Just a week ago bad news from the financial sector was shaken off and the indexes moved higher. What changed? A major motivator for trading was the Q1 earnings cycle and that is now over. Secondly we are heading into and option expiration where traders book profits from earnings plays. Lastly, we are heading right into the middle of the 10-day period where "sell in May" investors actually begin leaving the market.

Wilshire 5000 Chart - Weekly

The economics last week were almost invisible with very few reports to interest the markets. Next week that will change as we head into the normal end of month reporting cycle. The first key report on Wednesday is the Consumer Price Index or CPI and the Fed is expecting price inflation to decline. The street is expecting prices to continue to climb. If the Fed is right then the pressure will ease on expectations for future rate hikes. If the street is right and inflation is moving higher then the Fed will begin to get even more nervous about their current low rates and high stimulus posture. Last month prices rose +0.3% from February and +4.0% year over year. Core CPI was up only 2.4% year over year. Core CPI excludes food and energy prices and as we know those are the prices that are exploding higher. By excluding food and energy the Fed can say that inflation is low and actually slowing over the last couple months. That is like a service station advertising gasoline for $1.50 when they don't have any gas. Is gasoline $1.50 or $3.50? Is inflation 5% or 2%? It all depends on how you spin the numbers. The CPI report is 8:30 Wednesday morning.


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Next up is the Philly Fed Manufacturing Survey on Thursday. The survey showed manufacturing conditions in the Philadelphia region fell to -24.9 and a 7-year low in April. Not since 9/11 have conditions been this bad. Tight credit and weak demand are weighing on the manufacturing sector. New orders in April fell to -18.8 and weak backorders at -16.8 suggest it could be several months before the region recovers. Any number under zero represents a contraction. The headline number of -24.9 is expected to improve to -20 but still in a decline.

The NY-Empire manufacturing survey is Thursday morning but it is not as closely watched as the Philly Fed survey. Industrial production is also on Thursday. Consumer sentiment is out again on Friday but it would be hard to surprise traders with a continued drop. This is not a heavy calendar but there are enough reports to distract traders from the lackluster earnings calendar. Of the hundreds of companies reporting next week there were less than 10 that most traders would know. Hewlett Packard is biggest report of the week on Thursday.

Economic Calendar

The biggest reason for Friday's decline was the AIG disaster. AIG lost $3.87 on Friday, which accounts for about 32 Dow points. There was only one other Dow component down more than a dollar and that was ExxonMobil (XOM) at -1.11. AIG lost -8.35 over the last three days and that equates to more than 65 Dow points. With the Dow losing -312 points for the week AIG was 20% of that decline.

AIG Chart - Daily

The problem on Friday was an announcement that AIG lost $7.8 billion in Q1 and needed to raise $12.5 billion in additional capital. AIG said it lost 3.09 per share for the quarter. The losses came primarily from their investment portfolio and credit-default swaps. The swaps are promises to cover losses on $579 billion in bonds and other kinds of debt. Losses from their investments in debt backed by mortgages totaled more than $6.09 billion. AIG said it would raise $7.5 billion through an offering of common stock and another $5 billion through sales of fixed income securities. AIG has a market cap of about $100 billion so that share sale is roughly 7% dilutive. The stock offering will take place on Monday. The real question here is where will the pain end? Analysts thought AIG was done with their write-downs after the Q4 earnings disappointed. This seems to be a consistent trend that every quarter is producing additional losses from financial companies. Granted Q1 was the Bear Stearns quarter and could have been the bottom for valuations but until that starts showing up in financial earnings we won't know for sure. Remember, a major disaster in a Dow stock causes the Dow ETFs to fall sharply. That triggers sell stops on the ETFs and that causes more selling in the individual Dow stocks. AIG may have only accounted directly for 65 Dow points but indirectly through ETF selling that could have been nearly 100 points.

Citigroup (Nyse:C) held an analyst meeting on Friday and revealed they were going to sell up to $500 billion in non-core assets. That is an amazing metric. $500 billion in extra assets they have just laying around. Citigroup has about $2.2 trillion in assets so this trimming of the fat only amounts to about 20%. The sales will occur over time to avoid fire sale prices but it represents a restructuring of monumental proportions. This will include its mortgage portfolio and assets in their securities and consumer banking segments. Revenue is expected to grow by 9% through more cost cutting and layoffs. Citigroup has cut 13,200 jobs since last summer. They have written down $38 billion in assets since this crisis began. Analysts say Citigroup is being forced to take these measures to raise more capital because of their current exposure to home equity loans ($63 billion), mortgages ($150B) and $21B in auto loans. As consumer credit continues to spiral downward they expect additional write-downs and that requires additional capital.

After the bell on Friday FedEx warned on earnings for the current quarter. Warning after the bell on a Friday is the kiss of death. The CFO didn't just run into the CEO's office at 2:PM and say, dang we are going to miss estimates. We better warn! When a company warns after the close on a Friday they normally have something else to hide. They are hoping everyone went home early and will miss the news. FDX said earnings are now going to be $1.45-$1.50 compared to prior estimates of $1.60-$1.80. Analysts had already cut estimates from $1.95 to $1.69 after FDX initially warned for this quarter back in March. FDX said rapidly rising fuel prices were the reason for the warning. The CFO said fuel costs had risen by more than $100 million since the March warning. They have dynamic fuel surcharges in place but they said they were not dynamic enough to cover the rapidly rising prices. They also said the weak economy has restrained demand for U.S. domestic express package and LTL freight services. FDX declined to discuss earnings other than the published warning saying they were in their quiet period before their scheduled earnings release on June 18th. That should also be a red flag since a normal quiet period does not extend over five weeks ahead of earnings. FDX lost -$2.84 in regular trading and another $3.00 in after hours after the announcement.

FedEx Chart - Daily

Circuit City (CC) got a boost today after disclosing they will allow Blockbuster and Carl Icahn to look at the books. Blockbuster has offered $1 billion for troubled Circuit City. Icahn is a major shareholder in Blockbuster and he said he was prepared to buy Circuit City if Blockbuster could not raise the required financing. That relieved concerns that the Blockbuster acquisition would not complete since both are in trouble and financing could be a problem.

Oil prices continued their record run to close at $126 in extended trading. As evidenced by the FedEx warning this is becoming a major problem. It is not just the airlines raising prices 14 times since 2008 began. It is not just John and Peggy Consumer being faced with paying $3.67 or more for gasoline this weekend. This rise in oil prices is taking on a life of its own and the U.S. economy is going to suffer. The weak rebound that supposedly started in April could quickly be squashed if this continues. Over 60% of consumers claim they are facing hard decisions about how they are going to afford fuel. The gains on Friday were attributed to the Hezbollah takeover in Lebanon and new revelations on Hugo Chavez's involvement with the Columbian rebels. On Friday the Wall Street Journal published a report that suggested even closer ties between Chavez and the rebels than previously thought. The WSJ said it had reviewed computer files recovered in Columbia that showed firm offers by Chavez to arm and fund the rebels in exchange for their attacks in Columbia. Analysts are afraid the U.S. will put sanctions on Venezuela given the clear evidence Chavez is promoting violence in other countries. Venezuela is one of the top 5 exporters to the U.S. and should the U.S. put sanctions on Venezuela you can bet Chavez would halt shipments of oil to America in retaliation. Since he has to sell the oil to stay in power and the U.S. has refineries specifically tailored for his grade of oil it would still make its way to us but through middle men and that would raise oil prices again. In Lebanon the Iranian backed Hezbollah group seized the Muslim half of Beirut from fighters loyal to the U.S. backed governing coalition. Lebanon does not produce oil but violence there always pushes up prices on fears other countries will become involved. For instance, if the U.S. decided to punish Iran and Syria for aiding Hezbollah then oil supplies could be threatened. It is a complicated world when you start tracing all the oil supply ramifications to localized civil unrest.

June Crude Futures Chart - Daily

You would think with oil up +$10 in a week that oil stocks would be soaring. That is not the case and almost every oil related stock was down on Friday. Despite the $126 close on oil there is a growing number of investors who feel it has run its course and a correction is imminent. Unfortunately the landscape is littered with the skeletons of investors that have had that same thought over the last six weeks. I believe we are also seeing the pressure from another round of expirations next week. June crude options expire on Thursday and the June crude futures contract expires the following Monday. Those who were crushed by waiting until expiration to exit in the last two expiration cycles probably have vivid memories of the losses and are exiting early this time around.

Another reason given for the last three days of market declines is the win by Obama on Tuesday. Clinton's poor showing in North Carolina and the weak win in Indiana suggest it is all over but the crying. Obama will be the democratic candidate. Even Obama credited the win in Indiana to cross over republican voters who wanted to keep Clinton in the race as long as possible so the candidates would continue to pick each other to pieces. Rush Limbaugh reportedly organized Operation Chaos to mobilize republicans in Indiana. Obama admitted the plan worked. The market could be starting to price in an Obama candidacy and his frequent calls for higher taxes on individuals and corporations. Clinton policies would have had less change and a government more like the 1990s. Investors could have swallowed that pill a little easier according to the pundits on TV. Personally I don't believe it was a major factor in the selling but in these low volume sessions it does not take much of a spark to decide the direction.

The revelations from AIG and Citigroup suggest the credit crisis is not over. There are fears that Freddie Mac (FRE) will come to the market with earnings on Wednesday with a new disclosure of write-downs and new capital requirements. A JP Morgan private banker, Stuart Schweitzer, said on Friday that JP Morgan was decidedly uncomfortable with the market and was mostly in cash. They feel the crisis is not over and new revelations are still to come. They feel the housing crisis will worsen throughout the rest of the year, oil prices will continue to weigh on the economy and a consumer meltdown will be the next shoe to drop. CEO, James Dimon said at a meeting in Frankfort last week that he did not expect the financial crisis to end soon and JP Morgan would remain very cautious. "We can only speculate how deep and how long the recession in the U.S. will really be and how that will impact banks. We will not be done with the crisis for a long time Imagine we would need to announce to our shareholders one day, sorry but the recession in the USA is so bad we are broke. We need to be able to rule that out at all times so it will not come to that," Dimon said. Greenspan said this week he also expects the housing crisis to continue into 2008. He was widely misquoted earlier in the week as saying the worst of the credit crisis was over. He qualified that on Friday on CNBC saying it was over "IF" housing recovered and credit markets improved, etc, etc. He is never one to make simple statements.

Merrill was also out with a note to avoid seven sectors. Those seven were specialty retail, industrial conglomerates, capital markets, consumer finance, insurance, consumer services and health providers. They called them wealth traps at this stage of an economic recovery saying that historically they lagged other sectors under these economic conditions.

Next week has a lot of retail earnings and expectations are not very high. So far we have not seen the fallout from the economic downturn translate into weak sales. With gasoline going up daily it is only a matter of time before that does happen. Analysts are worried that we could see some guidance warnings next week. Major reporters are KSS, JCP, ANF, M, URBN and JWN. A weak showing by retailers could further pressure the markets.

The AIG opening plunge knocked the Dow below initial support at 12800. After that initial drop the selling was well contained and the opening dip to 12720 remained intraday support the rest of the day. The volume was very low at 5.9 billion shares across all markets and that was the lowest volume since April-28th and only the 6th time under 6 billion shares in 2008. Volume is a weapon of the bulls and it appears they are either out of ammo or just not fighting. We have seen a 1400-point rally off the March lows so a -300 week is not a disaster. The decline brought the Dow only back to uptrend support. However, a break here could be serious. The FedEx warning after the close on Friday will depress the Dow transports on Monday and probably the Dow by association.

Dow Chart - Daily

Nasdaq Chart - Daily

The Nasdaq continues to perform better than the Dow and only gave up -5 points on Friday. Support appears to be forming around 2440 and for two days that support has held. The Nasdaq could easily pullback to 2400 without doing any real damage to the uptrend. On Monday Research in Motion (RIMM) will officially announce the BlackBerry 9000 that some have been calling an iPhone killer. I have seen a demo on it and I don't believe it is an iPhone killer but it will definitely be a hot commodity. This could give RIMM and the Nasdaq a boost as long as they follow through with the release without any further setbacks or qualifications.

The S&P-500 is more troubling for me this weekend. My initial support level at 1400 was broken on Thursday but 1380 returned as a backup. With 1375-1380 only a gap open below the 1388 close there are several levels here that could continue to act as support. I recommended on Tuesday to reverse to a short bias under 1400 and I still have that recommendation today.

S&P-500 Chart - Daily

Russell 2000 Chart - Daily

A surprising thing happened during Friday's drop. The Russell 2000 did NOT drop and closed in the green. In fact 715 was solid support on both Thursday and Friday. The Russell futures closed up +3.20 and near the high for the day until the FDX warning. I was all set to change my bias based on the Russell but now we need to see how the FDX warning affects the open on Monday. With the Russell's close at 720 we are still 12 points away from a breakout level over 732 but the relative strength was encouraging.

To recap my expectations for next week I would be leery of the retail earnings. Hopefully enough people are expecting problems so anything they report will be an improvement. Watch the RIMM announcement on Monday for some tech direction. If oil continues higher ahead of expiration the market may start to pay more attention given the FedEx warning. Obviously oil's $15 rebound off the May-1st lows is extremely over extended but traders have the Goldman Sachs prediction as emotional backup for existing longs. It is a confusing trade when every fundamental is saying decline but prices are spiking. Watch for the CPI on Wednesday to cause some Fed anguish unless by some freak of nature prices fell last month. There may not be any single compelling reason for last week's losses but remember we are in exactly the right spot on the calendar for the sell in May and go away crowd to exit. That occurs after earnings and around options expiration. To rebut this cycle in 2008 we need the markets to hold these levels for the next two weeks. Otherwise we need to start targeting 1275 again on the S&P. I am not ready to make that call. I want to believe that the worst is behind us and this is just some minor profit taking. Of course we can believe what we want but we need to trade the charts and the S&P is in sell mode under 1400.

Jim Brown

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