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Market Wrap

Inflation Weighs

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Inflation was clearly evident in this morning's Producer Price Index and that report overshadowed positive earnings news from Goldman Sachs. Housing starts fell again, industrial production fell and the chance of a rate hike increased according to some analysts. All these factors weighed on the market ahead of next week's FOMC meeting.

Wilshire 5000 Chart - 30 min

The critical report this morning was the Producer Price Index or PPI. The headline number on the PPI rose a whopping +1.4% in June following a +0.2% increase in May. Prices were again influenced heavily by gains in food and energy. The core rate excluding food and energy rose only +0.2%. Price increases were sharp across all stages of processing. Prices for producer finished products are now +7.8% higher than May 2007. Prices for intermediate goods rose +6.2% in May and crude energy products rose +13.1%. The rise in price for heating oil and natural gas was also instrumental in boosting producer prices. Intermediate food prices rose +3.2% with the largest increases in beef and cheese prices. Prices for durable and nondurable goods rose by +4.5% and 3.2% respectively. The tame inflation in the April report was completely erased by the sharp increases in prices for June.

Housing starts declined -3.3% to 0.975 million units in May. Housing permits fell -1.3% for the month. This is the second time in three months that starts have been below 1 million units. Starts are down more than 30% from 2007 and -55% below their 2006 peak. Single-family starts decreased another 1% to 0.674 million units and this was the 13th consecutive monthly decline. Housing completions increased 11.6% in May. Homes that are started today won't be ready until Christmas and that is typically not a buying season. Odds are good most of today's starts are already presold. Builders try to start spec homes later in the year with a plan to get them ready for sale by March. The spring buying season lasts from March to June to allow moves before school starts again. I would expect starts to continue to decline for the next couple months.

Housing Starts

Industrial production for May fell -0.2% after a -0.7% decline in April. Capacity utilization fell to 79.4% and the lowest reading since the period after Hurricane Katrina in 2005. The outlook is for more of the same for the rest of the summer. The only material report left on the calendar this week is the Philly Fed Survey on Thursday.

The recent economics have played havoc with expectations for the Fed meeting next Tuesday. The chances for a rate hike have been spiking with the comments from the various Fed speakers. However, the housing numbers today actually reduced the chance of a hike while the inflation in the PPI had the opposite impact. By day's end it appeared the weak economy won with chances for a rate hike falling about 25% for the day to put the possibility for a hike a little less than 50%.

Goldman Sachs reported earnings this morning of $4.58 per share and that beat the street's estimates of $3.42 per share. It was a case of poor earnings across the sector depressing the outlook for the best performer. They were guilty by association. Goldman earned more than $2 billion for the quarter. You would think a beat of that magnitude would produce a spike in the stock price. Goldman stock fell -$2.65 because Goldman shares had risen +$25 over just the last week. Expectations were priced in and traders were taking profits. Goldman was exactly the opposite of Lehman and their $3 billion loss they reported on Monday.


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Goldman also said the credit crunch was not over and the $300 billion in write-downs in the sector was not enough. Goldman said continuing losses and write-downs may force US banks to raise an additional $65 billion of extra capital. This produced selling in all the banks and brokers with the XLF losing another 3% and closing in on the 52-week low once again. Lehman rolled over again with another 7% loss. Traders were hoping the Goldman earnings would energize the financials but the Goldman comments on the sector did just the opposite. Goldman said a broad based rally in financials was unlikely until the earnings outlook is lowered. Morgan Stanley reports earnings on Wednesday.

The Commodity Futures Trading Commission said changes were coming for the energy sector. The NYMEX and ICE exchanges will have identical position limits within 120 days. ICE currently has no limit. Other foreign exchanges will be forced to comply with the same rules as U.S. traders. The CFTC said it would produce a paper on speculation in the sector by Sept-15th. The CFTC said they were looking into the unregulated swaps among major financials like Goldman Sachs and how those swaps are reported to the market. The chairman of the CME cautioned again against raising margin requirements any more because lower volume in futures produces more volatility not less. He also said it would push traders into unregulated markets and could actually push prices higher rather than lower. The CEO of Nymex agreed with the need to keep margin requirements low saying the data clearly indicates higher prices when margins rise. Senator Joe Lieberman is scheduled to release on Wednesday details on three draft bills designed to curb financial speculation in futures and reduces position limits by institutions.

Crude oil chart - daily

Crude prices fell today to close just under $134 and although the volatility was high it was less than in recent days. Crude options expired at the close today and relatively speaking it was a calm expiration. July crude futures expire on Friday. The Saudi Arabia oil conference will be on Sunday and anything is possible. Saudi was going to announce another production increase of 200,000 bpd after the conference but the news leaked early and hit the markets on Monday. The New York Times speculated today that the government should RAISE taxes on gasoline to force consumers to buy higher mileage cars. In theory it is a good idea but in practice it would be politician suicide to force that on U.S. consumers. Obama said today that the strategic petroleum reserve should not be opened for price concerns but only for major disruptions in supply. However Obama is also pushing for a windfall profits tax on oil companies and does not want to allow offshore drilling. McCain said yesterday he favored lifting the 27-year old ban in offshore drilling. This was a reversal in his position since 2000 and reflects his changing outlook for future oil prices and energy security.

The impact of fuel costs on the economy could be seen in the FedEx earnings tomorrow. FDX and UPS have already warned that fuel prices were rising faster than their fuel surcharges and package volume was slowing. The FedEx earnings guidance could be key in forming an outlook for the economy and even in the Fed's policy response next week. However, after the close today YRC Worldwide (YRCW) raised estimates for Q2 profits to 30-40 cents per share. Analysts were expecting 29 cents. The upgrade came the day before CEO Bill Zollars presentation at the Merrill Lynch transportation conference on Wednesday.

This is option expiration week and so far the markets have been tame. Volume has been minimal with barely 6 billion shares traded each day this week. Decliners are increasing and internals suggest the bullish enthusiasm is declining.

The markets are looking weaker tonight with the Dow giving back -108 points to decline to 12160 at the close. I had hoped minor Monday rally in the financials would continue after the Goldman earnings but those hopes were dashed. The Dow failed at resistance just over 12300 for the 5th time in the last eight days. That suggests we are looking at another test of support at 12100 and the outlook is not good. The fear of the Fed still exists despite a cooling of rate hike concerns. Until financials recover the Dow and S&P will have trouble posting gains. If the Saudi oil conference produces some unexpected news that depresses oil prices that will be a second anchor on the S&P. The S&P failed again at 1360 and could be headed for a retest of support at 1325.

Dow Chart - Daily

S&P-500 Chart - Daily

The Nasdaq looked slightly better with a two-day rise to 2480 but it still gave up -17 points today. You can't blame today's decline on Apple with a +4.59 gain today on top of a monster gain on Monday. A research note from RBC said that Apple is likely to have a breakout quarter and could sell 14 million iPhones in 2008. His price target is $220. America Technology Research raised its price target for RIMM to $205 saying they expected a very strong quarter from RIMM. RIMM gained +$10 over the last 2 days. Offsetting the strength in AAPL and RIMM was weakness in the semiconductor sector. Downgrades in expectations were the reason for the decline. The Nasdaq is well above support at 2400 but continued financial weakness in the Dow and S&P could be a drag on the tech sector.

Nasdaq Chart - Daily

Russell 2000 Chart - Daily

The Russell could be setting up for a head and shoulders failure at 740. The rebound from last week's closing resistance at 730 was lackluster and the small caps are probably going to take their key from the Dow. There are quite a few small banks in the Russell and continued weakness there and in the semis could continue to restrict any rebound.

For the rest of the week there is no compelling reason to be in the market. We are hitting the warning cycle for Q2 and traders will want to be cautious. With the Philly Fed on Thursday and the FOMC next Tuesday along with those earnings warnings we could see a lack of interest in buying. Options expiration could supply some volatility but the low volume so far this week suggests traders are already spending more time planning the family July 4th outing than what stock to buy tomorrow. I would continue to be cautious about any long positions until proven wrong.

Jim Brown

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