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Dow Finds Traction

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The Dow powered for a +165 gain on Friday and became the only major index to finish the week higher than it started. Not bad for a Friday the 13th. It was an ugly week with major declines and trails of broken support. Is this rebound the start of something good or just the result of short covering before the weekend?

Wilshire 5000 Chart - Daily

The economic reports on Friday told us that we have no inflation in the U.S. and I am sure that is reassuring to everyone who is finding it harder to stretch those paychecks. Of course that low inflation rate is known as the core rate and excluded food and energy. If you don't use those items your cost of goods rose only 0.2% for the month of May. That core inflation rate is up only 2.3% over the last 12 months. Unfortunately for those of us who do eat and drive the inflation rate rose by +0.6%. The Consumer Price Index showed us that top line inflation rose by 4.2% for the last twelve months.

The largest single increase was energy prices which rose +4.4% for the month and a 28.2% annualized rate, and a 17.4% increase over the last 12 months. Food prices rose +0.3% for the month and +5.1% over May 2007. In reality all of these prices would be much higher were it not for the implosion in the automobile sector. Falling prices there knocked -1.1% off the number. Economists trying to explain the Friday numbers said that the +20.8% rise in gasoline prices was not really an issue since gasoline bills were such a small part of the consumer budget. Try telling that to Wal-Mart shoppers. They also pointed to the price deflation in many products as a sign that inflation was tame. Over the last 12 months television prices have fallen -16.8%, computers -13%, toys -5.2%, furniture -2.4%, women's apparel -5%, automobiles -1.2% and appliances -1.1%. Televisions and computers always go down because of improvements in technology continually reduce prices. Furniture and appliances are down because of the collapse of the housing sector.

The first reading of Consumer Sentiment for June fell to another 28 year low at 56.7. That was a sharp drop of -3.1 points over May. The current conditions component fell from 73.3 to 68.7 and the expectations component fell from 51.1 to 49.0. The impact of the tax rebate checks was unseen. Inflation expectations fell 0.1 to 5.1%. May's 5.2% reading was the highest level since 1982. The headline reading on sentiment is not only indicating a recession but a severe recession when compared to similar occurrences in the past. It is already -4 points below the recession in 1990. Unlike the CPI the Michigan Sentiment index is directly impacted by food and energy prices. The reduced availability of consumer credit is also putting stress on sentiment.

Consumer Sentiment Chart

For next week we have the Producer Price Index (PPI) on Tuesday and the Philly Fed Survey on Thursday as the key reports for the week. The PPI will give us an advance look on what to expect in the next CPI. Inflation has to filter through the producer level before it can get to the consumer level. Expectations are for a headline gain of +1%. The Philly Fed Survey on Thursday is expected to show an improvement to a -10 from -15.6 in May. Any negative number is still in contraction territory but at least the trend appears to be up from the -24.9 low in April.

I added the crude options expiration on Tuesday and the crude futures expiration on Friday to the calendar because crude prices are likely extremely volatile next week. With the Morgan Stanley target of $150 by July 4th there could be some early fireworks. The Saudi Arabia global oil meeting on June 22nd could also be a factor since most traders expect the meeting result to be additional oil on the market even if it is just a token amount for a short time. All OPEC has to do is "say" we are going to increase production by one-million barrels per day and the upward price spiral would begin to crumble. The fundamental basis behind the gains in crude is partly based on fiction and hype. Adding another million barrels to the mix could drown some of that speculation.

Crude Oil Chart - 60 min

The earnings for three major financial stocks will be announced and some believe that was partly the reason for Friday's rally. With all the bad news and expectations for bad news already priced into the stocks it was time to exit before some actual good news surfaced. Lehman reports on Monday, Goldman on Tuesday and Morgan Stanley on Wednesday.

Weekly Economic Calendar

The two quarreling kids are at it again. On Thursday it was big news that Microsoft was finally done with Yahoo and was no longer interested in doing a deal. Yahoo's stock fell -10% and Microsoft shareholders were cheering while Yahoo shareholders were getting the ropes and torches together to storm Jerry Yang's castle. Yahoo did a deal with Google to outsource its search advertising and immediately ignited another firestorm. Google has 75% of the search traffic and Yahoo 9%. How any regulator could approve that deal is astounding. Secondly, Yahoo spent $2 billion revamping its search-advertising portal over the last three years. Outsourcing to Google now admits that $2 billion was wasted. Deutsche Bank analyst Jeetil Patel described Yahoo's deal with Google as "one of the worst strategic maneuvers seen in the Internet industry." Since Google will be serving ads on Yahoo it is only a matter of time before advertisers switch to Google for the greater market share and knowing their ads will still run on Yahoo as well. ThinkPanmure analyst William Morrison said by letting Google inside Yahoo they would be able to gather even more information on the Yahoo search process and be able to translate it into the Google model. The research note was titled "Giving away the store."

Yahoo Chart - Daily

On Thursday Yahoo said it was "unequivocally" rebuffed by Microsoft during an attempt to renew negotiations. Yahoo shareholders had been clinging to the hope that Yahoo could rekindle the prior bid of $33. Yahoo stock was $19 just before Microsoft made the offer and at Friday's close of $23 it appears headed back to $19. But wait, late Friday Microsoft said it was still interested in a deal with Yahoo. This love hate relationship has more chapters than the bible. Microsoft said it offered to pay $1 billion for Yahoo search and buy $8 billion in Yahoo stock for $35 a share. Microsoft was also willing to guarantee Yahoo $1 billion a year in additional income from a revenue sharing arrangement as an incentive for Yahoo to do a deal. The deal with Google is only expected to bring Yahoo between $250-$450 million per year. According to Microsoft they offered the search deal after concerns rose about combining Hotmail, Yahoo mail and their instant messaging systems and possibly not getting regulator approval. Given Yahoo's declining market share that is not a consideration by most analysts.

If Microsoft ever decides to spend the money and go head to head with Google, Yahoo's scraps will be meaningless to the sector. Microsoft has already said they would protest the Yahoo/Google deal to regulators. They may never have to go that far with the Yahoo shareholder meeting coming up in August. Jerry Yang better get his bags packed in advance because the villagers are about to riot. Carl Icahn is almost certain to get control of the board even if the Microsoft deal is really dead. Shareholders are going to be so angry they will vote to throw all the bums out. Icahn will have to crawl on his knees to Microsoft after August to get a deal done but a deal of some kind will get done. Yahoo shareholders are pushing ahead with a suit against Yahoo in an attempt to get the poison pill severance plan removed even before the August shareholder meeting. They claim the hastily approved poison pill was a major reason Microsoft walked on the initial offer. Icahn has already said he will kill the pill as a first step to making Yahoo attractive if he gets control of the board. The second step according to Icahn will be firing Jerry Yang.


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Shares of Qualcomm (QCOM) hit a new 52-week high at $50 on Friday after raising its guidance for the current quarter and the year. QCOM predicted earnings of 54-55 cents compared to its prior forecast of 50-52 cents. Hand set sales were expected to be inline with prior estimates but the mix improved significantly with a greater percentage of high-end data-centric devices and wireless infrastructure upgrades. This led to higher prices and higher profits on that existing handset forecast.

Apple Inc (AAPL) stock continued to fall with a close at $172 on Friday. Thursday was really ugly with a drop of $8. The problem continues to focus on Steve Jobs health. You have heard the story about how he looked gaunt and pale when he announced the 3G iPhone at the WWDC last Monday. Rumors started flying almost instantly that his pancreatic cancer had returned. Initially the company said is was "just a common bug and he was taking antibiotics." That covers a wide range of possibilities but it did not end the rumors. Henry Blodgett said again on Friday that Apple is only making it worse by NOT saying specifically "his cancer has not returned." Until they do the rumors will continue to grow and the stock price sag. By not saying the cancer has not returned they are actually giving credence to the rumors. I think Apple is doing their shareholders a disservice by not killing this rumor quickly, if they can do it truthfully. I found one link that gave a very good explanation of why Jobs is weakened and skinny after his bout with cancer. It describes his surgery with diagrams from the Mayo Clinic. It is a miracle he is still alive. See this link for more information. Still Apple needs to come clean for the benefit of their shareholders.

Apple Chart - Daily

Hopefully the earnings from LEH, GS and MS will end the bloodbath in the banking sector. They are the single biggest drag on the major indexes. The regional banks are getting hammered on fears the asset base is shrinking through homeowner foreclosures and bankruptcies and dividends will be eliminated to reduce the cash burn. Foreclosures were up +48% in May. There have been several bank failures on the regional level and below and this is not producing confidence for the sector.

Remember Thornburg Mortgage? TMA was a mortgage company that had no subprime exposure. They only wrote jumbo loans to Alt-A credits and above. Unfortunately the subprime crisis reached up and snatched them off their lofty perch and down into the slime. The drop in value for mortgage backed securities forced them to buy back billions in AAA+ MB securities with no place to sell them. They avoided bankruptcy by raising enormous amounts of capital and finally agreeing to sell 48% of the company at a penny a share in exchange for another capital infusion with an interest rate of 18%. I could go on but the point of this story is that TMA had no problems of their own. The credit crunch reached out and strangled them from afar by devaluing perfectly good mortgage loan paper. Investors are afraid this is what will happen to the regional banks. They are afraid many are carrying loans on their books at face value when they are really worth substantially less in the market. I could have a $500,000 home loan on a million dollar home and be paying exactly on time each month as agreed. If my loan was packaged and sold with hundreds of others in a mortgage backed security then it could be valued today at 60 cents on the dollar simply because the market value for MBS loans had fallen due to market conditions. Once the regional banks have to acknowledge these values as well as the hit from rising foreclosures then investors believe quite a few could be in danger. This is depressing the stocks of otherwise healthy banks.

Thornburg Mortgage Chart - Weekly

Wachovia Chart - Weekly

Downey Financial Corp (DSL) said on Friday that one-seventh of its total assets were now non-performing. Bad loans had risen 900% over the same period in 2007. Non-performing loans were 1.3% in May 2007 and 14.3% today. On June 1st 2007 DSL shares were $74. Today they are $4.97. Similar problems exist in the larger banks. Wachovia (WB) has fallen from $55 to $18 and a 16-year low on Friday. WB is expected to cut their dividend amid further deterioration in their assets. Wachovia's asset base is similar to Downey's because they acquired Golden West Financial at the height of the housing boom. Fifth Third Bancorp (FITB) was cut Friday morning on growing concerns over loans, charge offs and a potential dividend cut. The downgrade sent it to a 13-year low. Bank America (BAC) is under fire for its acquisition of Countrywide because they have the biggest portfolio of loans in the business. The pain being felt at DSL and WB is going to be magnified at Countrywide. The problems at these majors suggest the smaller local banks could be in hot water since they don't have the access to capital the bigger banks have.

Downey Financial Chart - Weekly

The Dow rebounded +165 points after finding surprise support at 12100. The rebound was surprising after the CPI news but it appeared traders are following the Fed's party line of low core inflation. The +0.2% core rate was actually benign if you believe the Fed. After two days of bumping along at 12100 as support they suddenly took a benign CPI report as good news? I find that hard to believe and instead believe it was option expiration moves and short covering. Funds tend to roll out of their option positions the week before option expiration. The Friday before expiration tends to be volatile and we saw a perfect example this week. We also know that as of the end of May short interest was at record levels. Record short interest on stocks also translates into short interest on options. After two days of support at 12100 I believe the funds and anyone else short just decided to take profits and cover ahead of next week's financial news and expiration. As short squeezes go it was still rather pathetic. How do you know it was a short squeeze? Because those most heavily shorted sectors like airlines, homebuilders and financials spiked abnormally.

DDow Chart - Daily

Overhead resistance on the Dow is now 12350 and a level that was support the prior week. If the G8 ends positive this weekend with some comment on a stronger dollar then the market could remain positive. However, what Lehman, Goldman and Morgan Stanley say along with oil prices will have more impact than the G8. The current range on the Dow is now clearly defined between 12100 and 12600. Odds are good it will spend more time at the bottom than the top.

We are approaching the warning cycle for Q2 and it remains to be seen if we are going to have a flurry of warnings or more good news like Qualcomm. With the evidence for a recession still rather absent there is a potential for earnings to be better than expected. Everyone guided lower in Q1 and maybe that downturn failed to appear. We know from retailers that customers are still buying and sales have been better than expected in many sectors. Earnings guidance over the next two weeks will be key in market direction. The Fed meeting is only seven days away and it appears traders are actually wishing for a rate hike. I know that sounds crazy but it would be beneficial for the dollar and send a message that they are serious about fighting inflation.

Nasdaq Chart - Daily

The Nasdaq has been at the mercy of the declines in AAPL, RIMM and GOOG. On Friday it benefited from gains in two of those stocks. GOOG was up +18 and RIMM +3.37. FSLR also helped with a +12.50 move, BIDU +11, ISRG +11 and AMZN +3. The Nasdaq spiked at the open both Thursday and Friday but Thursday's +38 point spike failed to hold. However Friday's +50 point spike did hold and it closed at the high for the day. Support both days was just below 2400 and exactly where it should be. AMG Data said that fund flows out of techs could end in June. Over the past five months the amount of money flowing out of tech funds has dwindled to a slow drip. Jan -$788 million, Feb -$339, Mar -$437, April -$168, May -$27 and so far for June they have seen inflows of +$3 million. This suggests that the worst is over and we are about to see a reversal of fortunes for tech stocks. For all funds inflows have averages $1.67 billion over the last four weeks and that is up from $800 million the week of April 23rd. Last week's reading was the largest inflow since March 2007. Support at 2400 should be decent but it may be a little early to expect any big money to flow back into tech funds. The Nasdaq is setting up for a nice run once that money does start to appear.

The S&P is less positive with support appearing at 1340 on Wednesday. The rebound was lackluster due mostly to the weak financials. I would still not be a buyer of the S&P chart today. The summer range, assuming no improvement in the financial sector, could be 1275-1400.

S&P-500 Chart - Daily

Russell-2000 Chart - Daily

The Russell spent three days under 730 and my level to be short. The Russell spiked +8 points in the closing minutes on Friday to edge back over that level to 733. I would not be a buyer here. I believe it was option related short covering and next week could be rocky in terms of earnings and economics. There is no compelling reason to be long the market today. Of course that means we will probably blast off to new highs on Monday on some obscure news item. Remember, short interest was at record levels at the end of May and I doubt everyone has covered. The general market sentiment expects financials to crash and burn in this earnings cycle and take the market with them. If LEH, GS, MS accidentally said something positive next week to suggest the worst is over all those shorts would have nowhere to hide.

We should be somewhat encouraged by the 28 year low in consumer sentiment. Since 1970 when sentiment has been in a trough as it is today the next 12 months have been outstanding. There have been six recessionary sentiment bottoms in 1970, 1975, 1980, 1982, 1991 and 2001. The market rebounded strongly in five of those six cases. The average gain over the next twelve months was 14% with the low 9% and the high 31%. The only exception was the 2001 recession where the markets declined 18% in the following 12 months. Obviously the reason for the 2001 decline was not the recession but the aftermath of the 9/11 attacks. The world was changing as we knew it and the market reflected that change. If you eliminate that sentiment trough then the future is bright. The key here is finding a bottom. Until that bottom appears we don't know where to start the clock for the 12-month rebound. Stopping all the recession talk would be the first step. Something needs to happen to turn the conversations away from the impending recession to the impending rebound. Maybe this earnings cycle will be the catalyst if companies are not proclaiming dire times ahead. If not then the next pivot point could be the Q3 earnings and that is a long way off from where I sit.

Don't forget the Association for the Study of Peak Oil (ASPO) is holding their annual conference in Sacramento on Sept 21-23rd. This is a full 2.5 days of intensive, as in 8:AM to 9:PM information overload from dozens of experts from around the world on the status of Peak Oil. The cost is minimal at $325 because they are a non-profit and make no money on the event. Follow the link below to register and join me there. We can discuss each presentation and plan trades for the coming year. Put my name in the "how did you hear" box so they can group us together for the meetings. Go here to register:

Jim Brown

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