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Market Wrap

Market Divergence

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After a rocky week the major indexes can't seem to agree on a direction. Economic issues remain mixed but the Fed has made it clear the next rate move will probably be a rate hike. That does not seem to be worrying traders as long as the economy is recovering. However, the current state of the economy is still unknown with mixed earnings guidance still clouding the issue.

Wilshire 5000 Chart - Daily

The economics on Friday were positive and continued to cast doubt on the direction of the economy. The Chicago PMI came in at 49.1 and well over consensus of 48.5. Moody's Economy.com was predicting 47.5 and a retracement of gains made over the last two months. The PMI surprised analysts with a four-month high. The low was made back in February at 44.5. Anything under 50 is still in contraction territory but conditions are definitely improving. This is the first time the PMI has been under 50 for four months since the 2001 recession. New orders rose from 53.0 to 56.1 and backorders rose from 39.5 to 46.8. The employment index jumped from 35.2 to 41.2. On the downside the prices paid rose +4.6 to 87.5 and the highest level since June 2006. This inflation is slowly filtering into consumer prices and it will be a problem for the Fed.

The NAPM-NY report also rose slightly in May but you would need a magnifying glass to see it. The index rose only 0.2 to 419.8 but the good news was a halt to the four-month decline. The six-month outlook component spiked to 62 continuing its rebound from 44.2 in January. The current conditions component rallied back into expansion territory at 50.4 from its low of 37.6 in April. This was a positive report despite the microscopic gain in the headline number. However, in a special question added to the May survey 62% of firms said they expected slower profit growth during the remainder of 2008. We should not complain about slower growth when the other option is a decline.

The last reading on Consumer Sentiment for May was revised slightly from 59.5 to 59.8 but it was still a 28-year low. Inflation expectations continued to rise with one-year inflation expectations now 5.2%. Five-year inflation expectations are now 3.4%. This is the highest level since 1996. The current conditions component rose 1.2 points from the preliminary reading. This may be grasping at straws but it could be a sign that consumers believe the worst is over. With some rebate checks already being cashed this could have provided the minor uptick in sentiment. Sentiment is heavily influenced by the price of food and energy. Food prices have actually risen faster than energy prices over the past year as evidenced by the CPI so it is surprising sentiment did not fall even further.

Consumer Sentiment

Personal Income rose +0.2% in April, a drop of -0.2% from March. Spending growth also fell from 0.4% to 0.2%. The core PCE deflator rose +0.1% and savings held steady at 0.7%. Purchases of high dollar items like large flat screen TVs has slowed significantly. Real durable goods spending has risen only once in the last seven months and has fallen -3.6% over that period. Income has slowed as the job market weakens. Consumers can no longer fall back on their home equity to cover the shortfalls.

The CEO of Public Service Electric and Gas (PEG) said on Friday that disconnects for non-payment of utility bills had risen sharply and payment delays were becoming very prevalent. When consumers can't pay their utility bills they are definitely in trouble. The CEO also said they wanted to hike gas prices 20% starting in October to cover the increased cost of natural gas. Prices have risen from $7 to $11-$13 during heating season. The average customer bill would rise +$28.60 per month.


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Next week the economic calendar begins with the May ISM Index on Monday. Expectations are for another month in contraction territory at 48.5. That would be flat with the 48.6 seen in April. Some analysts are expecting a further decline to something in the 47.0 range. If the ISM remains in the current range that would mean the low of 48.3 back in February is still intact. In April the new orders were unchanged at 46.5 and its lowest level since the 2001 recession. This will be the number to watch on Monday's report. The ISM Services will be released on Wednesday and expectations are for 51.0 and only a point below April's 52.0 level.

The biggest report for the week is the Non-Farm Payrolls on Friday. Expectations are for a loss of 60,000 jobs. After three months of job losses over 75,000 per month we saw a minor 20,000 job loss in April. If jobs remain negative along with the ISM then the Fed will likely remain on the sidelines with no change in rates when they meet in three weeks on June 24th. There is almost no chance of another rate cut.

April Jobs Chart

On the stock front Dell's earnings and guidance energized tech stocks sending the Nasdaq to a 14 point gain for the day and a +78 point gain for the week. Semiconductors also rallied on the Dell news and the SOX closed up 15 points for the week or +3.7%. Dell rose +5% to $23.06 on their strong earnings but Marvell Technology (MRVL) beat them by a mile. Marvell earnings powered the stock to a 23% gain to close at $17.36. Dell said growth was at two-year highs with weakness in the U.S. being offset by strength in the international markets. Also helping to power the Nasdaq was another $2 gain in Apple (AAPL). Rumors are growing that Apple will announce the 3G iPhone over the next two weeks and availability will be immediate.

With May trading now in the record books the sectors fairing the worst were airlines at -18% thanks to $130 oil. Banks also lost traction and fell -8% along with a 5% decline in housing. Banks declined on fears that the Fed would be raising rates soon and on worries about the growing borrowings at the Fed's discount window. Borrowing on Wednesday hit $19.04 billion and average daily borrowings by banks rose to $15.95 billion and a new cycle high. This suggests the banking sector is still under a great deal of stress since borrowing at the discount window is considered a last resort. Borrowings by primary dealers averaged another $12.33 billion per day. Fed regulators closed a failed Minnesota bank called First Integrity and the FDIC was appointed as receiver. The bank was small with only $54 million in assets and $50 million in deposits but it underscored the worry about other failures to come. This was the 4th bank to fail in recent weeks. These worries have prompted a sell off in financials after the Fed backed rally lost steam.

Friday was a slow news day and volume was very anemic. Energy continued to be the focus after that $135 spike and drop back to $125 on Friday morning. Fears of change in rules by the Commodity Futures Trading Commission (CFTC) sparked a sell off on Thursday despite a multiyear drop in oil inventories. Crude inventory levels fell by -8.9 million barrels for the week ended May 23rd and pushing inventory levels to 9.7% below the same period in 2007. Inventories are at their lowest level since hurricane Katrina. Gasoline levels fell by -3.2 million barrels. Either of those numbers would have been good for a massive spike in price had it not been for the CFTC announcement they had been conducting a six month investigation into possible market manipulation by futures traders.

July Crude Futures Chart - Daily

The CFTC also said it was taking steps to improve the transparency of the energy futures markets. Some of those steps included monitoring the trading of U.S. futures traded on overseas exchanges and requiring traders to submit more detailed data regarding their index trading activities. This may have scared some players operating on the edge to bail with profits rather than be subject to some unexpected new rule change. There have been rumors for months that some sovereign funds from OPEC nations were behind the sudden ramp in oil prices. They have billions available to use for speculation or in concert to unobtrusively move the market. They can do it with relative obscurity from outside the U.S. by utilizing swaps with major U.S. banks and hide from position limits and from some reporting regulations. The total value of all open positions in crude futures was $174 billion on April 22nd. That is up from $17 billion in 2003. Even at $174 billion it would not take very much money to manipulate the price of oil since all you need to manipulate is the current month. That is only a fraction of the $174 billion and you need far less to buy a futures contract on margin.

How mad would the U.S. be to find that Iran and Venezuela might have joined together to manipulate the futures prices? It would be an ugly event with far reaching ramifications. We may never know what happened in the past because these complex trades leave few trails. New CFTC rules require significantly more reporting and identification of traders. The Acting Chairman said, "The agency continues to pursue one of its primary missions - to deter, detect and punish futures market manipulation." It may have just been fear that the CFTC would find evidence of somebody manipulating and those riding the coattails of the rally would be burned when the manipulation stopped. The chairman also said, "raising the margin requirements on commodity futures would be a dangerous idea and could send traders elsewhere." That could actually reduce the liquidity in the markets and increase volatility.

Whatever the reason the futures market saw significant selling on Thursday after the CFTC announcement was made. Support at $125 appears to have held and with hurricane season starting on Sunday I doubt prices will fall much further. Hurricane forecasters are predicting 9 hurricanes and odds are good at least one will be in the Gulf. If it happened to head for the oil patch we could easily see $135-$150 oil very quickly. Greenspan had to get his two cents in and remind everyone he is still alive, stirring up trouble and promoting his book. He said the rise in oil prices was part speculation and part supply and demand and prices will likely continue higher.

The Q1 earnings cycle is over and analysts are trying to refine their projections for the coming quarters. Estimates for Q2 have fallen since April 1st from a decline in earnings of -2% to -7%. Q3 estimates have fallen from +17.3% to +13.6%. Analysts say comparisons are favorable for Q3 because Q3-2007 is where the sharp decline in earnings began. For all of 2008 earnings are expected to fall from +13.5% growth to +8.5% if you include financials. If you eliminate financials that number rises from 8.5% to 11.6%. Energy is the only sector where estimates have increased going from 10% to 16%. Financials have fallen from -31% to -44%. Techs fared better with only a minor drop in estimates from 18% to 15%.

The dollar had a good week with a rise to 72.86 on the US Dollar Index. There is still strong resistance at 73.5 but traders are counting on those lows from April as being the bottom. With the next Fed move likely to be a rate hike and the economic indicators appearing to firm the dollar is more likely to move higher than lower.

US Dollar Index Chart

Sell in May? For the first two weeks in May I warned several times that we would not know if the sell in May crowd would appear until the week after expiration. Expiration was May 16th and starting on Monday May 19th the Dow fell -687 points from its high in only six days. There were plenty of events blamed for the decline but they could have just been coincidental. The good news was the rebound from those lows. There were plenty of buyers waiting for an entry point.

Dow Chart - Daily

The Dow was the weakest of the major indexes with only a minor +190 point rebound. Based on the Dow chart alone I would still be bearish on the markets. However, we know that stocks like GM, AIG, Citi and BAC have been a serious drag on the Dow but it may surprise you to know that Exxon (XOM) is also at a 3-week low. The Dow is struggling from its relatively narrow breadth of only 30 stocks. Support at 12500 needs to hold or the Dow will eventually tank the stronger Nasdaq. The Dow has a menacing chart with a potential double top at the 200-day average.

The S&P-500 has followed the Dow in its relative weakness primarily because of the influence of the financials on the index. 1395-1400 remains a pivot point with 1375 critical support.

S&P-500 Chart - Daily

Nasdaq Chart - Daily

The Nasdaq declined from 2551 to 2430 in the days following option expiration for a drop of -121 points. Unlike the Dow the Nasdaq rebounded +92 points to close at 2522 on Friday. Tech stocks, primarily led by the chip stocks, are on fire. This is unusual for this time of year and suggests a longer-term bullish bias.

The most bullish indicator for the broader market remains the small cap Russell-2000. The Russell declined to initial support at 730 and struggled to hold there for three days before starting a rebound that pushed it to its highest close in five months on Friday at 748.28. You read that right, the highest close in five months, a new relative high. That represents a 30 point rebound or +4.1% off last Friday's lows. When the Dow and Nasdaq sold off at Friday's close the Russell futures also took the plunge but immediately recovered to close at the highs for the day. Because the Russell is the sentiment indicator for fund managers this suggests they are expecting the markets to move higher. Specifically they believe the worst is over and they are willing to move into more risky investments.

Russell-2000 Chart - Daily

The setup for next week has a lot of qualifiers. If the dollar continues to rise then gold and possibly oil could decline. If oil rebounds then the S&P should follow it higher. If the momentum trade in oil has ended and support at $125 breaks then the S&P could follow it lower as energy stocks decline. The S&P is hostage to the three largest sectors of financials, energy and technology. Techs are not strong enough to rescue the S&P if oil rolls over. Financials are already in sell mode so 2 of 3 major sectors makes a majority and the S&P should decline on falling oil. S&P 1410 and 1420 are the key levels to watch if the S&P starts higher. A failure at 1375 would be a critical turning point. The critical point to watch on the Russell would be 750. A move over 750 would be a clear breakout and I would add to longs over 750.

The ISM and Jobs reports will also be key. A weaker than expected ISM could weaken market sentiment with the Fed already telling traders they are not going to cut rates again. Likewise the jobs report could be a negative for sentiment if it surprises to the downside with a loss of more than 60,000 jobs. If either or both reports come in better than expected they will confirm a rebounding economy and the Fed will no longer matter. That would help confirm the bullish bias the Russell is giving the market. Hurricane season starts on Sunday so expect to hear about it in the news and that could support oil prices. Tropical storm Arthur formed off the coast of Belize on Friday and appears headed to the Mexican side of the Gulf next week. That could get the oil speculation started once again.

Jim Brown

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