Option Investor
Market Wrap

Summer Witching

HAVING TROUBLE PRINTING?
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The summer doldrums are in full swing and Friday was a quadruple witching. Need I say more? That alone is a recipe for a decline but there were plenty of other negatives adding to the momentum. The Dow fell to within 80 points of the March lows as the selling in the banking sector intensifies. Add in ratings downgrades by S&P and Moody's and it was not a fun day for the bulls.

Wilshire 5000 Broad Market Index Chart - Weekly

There were no material economic reports on Friday. The only one of note was the Mass Layoffs for May, which rose to 1,626 events involving 50 workers or more. The May layoffs hit 171,387 compared to 133,914 workers in April. This suggests the labor picture is declining but you need to realize this is a lagging report for May and the announced layoffs will take place over several months, not all in May. The announcements are usually forward looking like "we are cutting 1100 employees by year-end." Construction and manufacturing have fallen the most with a sharp deterioration over the last two months. Manufacturing is being hurt by the sharp drop in automobile sales with production falling to 1998 levels.

Next week the calendar is busy but with few material reports. The Richmond Fed Survey on Tuesday and Kansas Fed Survey on Thursday along with the GDP will be the only items of real interest. The big event on the calendar is the Fed meeting on Tue/Wed. The rate announcement will be 2:15 on Wednesday and that is going to heavily influence the markets.

Economic Calendar

The Fed is caught between a rock and a hard place or in this case recession and inflation. The ammunition to fight either feeds the other. Cutting rates feeds inflation and raising rates feeds the recession. Their best alternative is to do nothing and that is what the market is expecting as of Friday. Chances of a rate hike have decreased sharply this week. However, the "whip inflation now" or WIN crowd is lobbying for a rate hike regardless of the impact on the recession. Richmond Fed President Jeffrey Lacker is adamant that "reversing rate cuts now makes eminent sense." And, "Just as easing policy aggressively in response to emerging downside risks makes sense, withdrawing some of that stimulus as those risks diminish makes eminent sense as well." Lacker is no stranger to the markets because he is a constant inflation hawk. He voted against several of the rate cuts saying inflation risks were already too high. Other Fed officials have also been making comments on inflation that were seen as hawkish and that pushed the chances of a rate hike higher.

The various news items on Friday diminished the chances of a hike significantly. S&P warned that it was putting GM, Ford and Chrysler on negative credit watch because of the falling auto sales. Moody's also lowered its ratings on Ford and Chrysler. Both said the sudden and significant drop in auto sales, specifically trucks and SUVs, was a bad omen for the automakers. Sales have fallen to 1998 levels. Liquidity for the big three for the rest of 2008 does not appear to be a problem. However, S&P said if sales don't pickup sharply in the first half of 2009 their liquidity levels could reach "undesirable levels." Not only have sales dropped off a cliff but it is especially painful that their highest profit lines of trucks and SUVs have been the hardest hit. I seriously doubt this is going to change soon. Ford said it was putting off the release of the redesigned F-150 pickup, the largest selling vehicle in the world, until they clean out the inventory of the older models. The downgrade on the automakers and the negative comments about sales would definitely weigh on any rate hike chances next week.

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Another factor weighing on the Fed is the bearish comments out of the banking sector this week. Citigroup fell under $20 on comments that loan losses could produce significant additional write-downs. Goldman Sachs said on Friday that the credit crunch was ongoing and would not peak until 2009. Credit losses would increase, loan loss reserves would need to be increased and capital raises would become much harder. Every capital deal done over the last three months is now underwater. Merrill said on Friday that loan losses in the banking sector would materially weaken earnings and they saw no improvement until 2010. All the major banks have said the consumer is under serious pressure and future defaults, foreclosures and bankruptcies were expected to increase. The Fed will find it very tough to justify raising rates under these conditions.

Lastly the bond insurers are in trouble again. Moody's downgraded bond insurer MBIA (MBI) by two notches to A2 from Aaa. This was much harsher than expected and literally shuts the door on new business for MBIA. The stock dropped 13% from $6.45 to $5.60 but that is not the problem. This puts MBIA $2.6 billion short of the capital needed to regain an investment grade rating. MBIA said it only has $1.1 billion in capital and would probably have to post an additional $4.5 billion in eligible collateral to satisfy potential collateral posting requirements under existing contracts. Moody's said their exposure to mortgage backed securities had risen to $5.9 billion as of last week. The ratings cut on MBIA will cause the ratings to be cut on hundreds of billions of bonds MBIA insured. This means holders of those securities will in some cases be forced to sell them because of rules regulating the quality of investments they are allowed to hold. For instance money market funds cannot hold securities that are not in the top two categories. This would knock those securities out of that range and force their sale. Moody's also cut the rating on the other major insurer, Ambac, to Aa3 from Aaa. Just when the Fed thought the worst was over these ratings cuts are putting about $1 trillion in bonds in jeopardy. Can the Fed afford to raise rates in this environment?

MBIA Chart - Weekly

I am betting against the Fed changing rates. That does not make the 2-day meeting any less of a market event. Traders are likely to remain on the sidelines until the smoke clears on Wednesday. The Fed will likely claim inflation is now more of a threat than recession and talk tough about mounting an aggressive fight but in the end do nothing. I am not sure it will help the market or not because those same points I made above are still negative for stocks.

August Crude Oil Chart - 120 Min

Crude prices firmed to gain +2.69 at $135 ahead of this weekend's meeting in Saudi Arabia. Friday was also the last day of trading for the July contract. Oil was expected to be weak ahead of the weekend meeting but news from around the world erased those expectations. It was reported in the New York Times on Friday that Israel had staged a maneuver over the Mediterranean and Greece that had all the appearances of preparations for an attack on Iran's nuclear facilities. The mock raid involved more than 100 Israeli F-15 and F-16 warplanes along with aerial refueling tankers, helicopters for pilot rescue, radar planes, etc. The warplanes flew more than 1400 kilometers, about the distance from Israel to Iran's nuclear enrichment facility in Natanz. This major exercise was obviously designed to demonstrate their capability of striking Iran as they have promised if Iran continues uranium enrichment. The U.S. confirmed the maneuvers and the potential of an attack on Iran. This was clearly designed to send a message to Iran and to the world that Israel was not making idle threats to end Iran's nuclear project. Israel destroyed Iraq's reactor facility in 1981 and a nuclear site in Syria several months ago.

The potential for an attack on Iran sent oil prices spiking early Friday to $136.80 but the Israel/Iran scenario was not the only market-moving event. Shell declared force majeure on 225,000 bpd of June and July production from Nigeria after the rebel attack on Thursday. That is a huge amount of light crude off the market for the next six weeks. A Chevron pumping station in Nigeria was attacked on Thursday night but there was no word on production declines. Chevron was also in the news as talks with workers in Nigeria fell apart and a strike is expected. A strike would impact Chevron's daily output of 350,000 bpd in Nigeria.

Those news events offset the negative price impact of the impending meeting in Saudi Arabia. The rumors are flying and I don't have the space to get into all of them here. Saudi already leaked that they will announce a production increase of 200,000 bpd at the conference. That leak has been making the rounds for a week. The newest rumor is that the announcement will actually be an increase of 500,000 bpd. That would take Saudi output to an even 10 million barrels per day and a level that many analysts doubt they can achieve. "IF" they actually bumped the announcement to 500,000 bpd "AND" actually managed to pull it off then it would be very bearish for oil prices. Saudi appears dead set on lowering prices and to emphasize their commitment they announced on Friday they were spending $90 billion to increase production to 12.5 mbpd by the end of 2009. This is not new news but their reiteration only days before the meeting suggests they are serious about talking down prices. That has been an impossible task recently. For the last two weeks oil prices have stabilized just under $137 and that suggests the oil bulls are running scared that the Saudi meeting could pressure prices next week.

In stock news Yahoo announced the departure of several executives. The brain drain included senior executives focused on search, email and services such as photo sharing, are departing. Current president Sue Decker is reportedly considering a reorganization that would centralize Yahoo mail, search and home page divisions into a global product organization. The brain drain and the rumors of a major reorganization knocked YHOO back to $21.99 on Friday.

In a major last minute market shocker SunTrust Banks (STI) said late Friday that it did not see any need for a dividend cut or to issue new stock or raise capital. They reaffirmed their charge-off and capital ratio guidance for Q2. They took this unusual step of announcing this late Friday to counter the sell off in the financial sector and in their stock price. Merrill Lynch comments earlier in the day suggested STI would be forced to cut their dividends. The move worked and the announcement lifted them +$3.50 off their lows. Huntington Bancshares (HBAN) had already shocked investors when they affirmed their prior guidance earlier in the morning and said charge-offs would not exceed prior estimates. HBAN spiked +30% on the news.

SanDisk (SNDK) was hammered after Citi downgraded them to hold from buy citing slowing demand in Asia and slowing handset orders from European companies. "Contract pricing weakness ahead of a seasonably strong build period along with demand erosion point to a loosening of fundamentals for NAND-based flash memory cards in the second half of the year" according to the Citi analyst. SNDK fell -10% on the downgrade.

Determining market direction for next week is no easy task. There are many conflicting factors which taken together could cancel each other out. The bear market in financials is becoming worse. The PHLX Banking Index (BKX) closed at 62.72 and a new 10-year low on a weekly basis. The Merrill, Goldman and Citigroup comments over the past week suggest there is more pain to come and in Merrill's view we may not see a rebound until 2010. If that is true there is almost no way for the broader markets to rise. The financials are the biggest component of the S&P. No financial rally, no market rally, period. The downgrades on the bond insurers will cause an entirely new ripple down effect for that trillion dollars of bonds insured by Ambac and MBIA. This will cause more write-downs and capital raises all down the food chain. This suggests there really is more pain ahead. The earnings warning cycle will be in full bloom next week.

The consumer is struggling as we saw with the bankruptcy and foreclosure numbers. The rise in the mass layoff numbers indicates the weak job market should continue. The Saudi oil meeting could send oil prices lower and oil stocks would follow. At 18% of the S&P that, along with the banks, would be a win for the market bears.

On the flipside no move by the Fed is already priced into the market. A positive statement of some kind could actually give the market a lift. There are six trading days left in the quarter. With a large amount of cash on the sidelines and NYSE short interest at a record high as of last week at 4.6% of all outstanding shares there is plenty of kindling for a bear-b-que. That is 17.65 billion shares short compared to the previous record of 16.43 billion on May 30th. The last three days of a quarter and first four days are generally bullish as retirement funds are deposited and put to work. Lastly the Dow is only 102 points away from the March closing low. This would be an excellent place for the bulls to produce a rebound. At one point on Friday decliners on the NYSE were outpacing advancers by 10:1. By the close that had improved to only 5:1. Still bad but indicated buyers had stepped in. It was probably just short covering ahead of the weekend but you can never tell.

The markets on Friday were heavily influenced by the downgrades on the automakers, financials, bond insurers, chip stocks and by the quadruple witching option expiration. If that was not a quintuplet of shocks to the market's foundation I don't know what is. Volume was very high at more than 9 billion shares. Was it a short-term capitulation? Who knows for sure but the market and especially the Dow is very oversold. Even the oil stocks have been losing ground despite rising oil prices. Granted it is summer and there is no compelling reason to own stocks right now but there is always a reason to own the right stocks as one reader pointed out as a rebuttal to that statement I made last Tuesday. Unfortunately even the right stocks go down in a bear market but that becomes a buying opportunity for those with risk tolerance.

That brings me to my final point. Funds have been sitting on a pile of cash while waiting for the market to pick a direction. Three weeks ago the Russell 2000 was breaking out as eager fund managers were starting to nibble on the "worst is over comments" coming out of the Fed. That idea cratered with the current round of problems and everybody is back in cash. Extremely oversold, a 10:1 A/D line, end of quarter window dressing, new retirement money, record short interest and the Dow within 102 points of its March closing low. That all adds up to a potential bear-b-que and we could see it next week. The SunTrust (STI) and Huntington Bank (HBAN) positive guidance could have been the leading edge of some good banking news for next week. There is absolutely no way to predict which of these scenarios will play out next week but I believe the fuse has been lit for a sharp rebound even if it is only a couple days in length.

The Dow closed at 11842 and gave up -220 points for the day and -464 points for the week. FYI the markets have been negative for 7 of the last 11 Fridays. The March closing low was 11740 and that is the level to watch. The Dow dropped below that level twice in January but rebounded to close higher both times. If the Dow closes below 11740 then all bets are off and we start looking for the next support level, which could be well below at 10700. That would be another thousand-point drop but there is nothing of any significance in terms of support between those ranges. Under 11740 is where the bears put everything in cruise control and take a thousand point nap.

Dow Chart - Weekly

Nasdaq Chart - Weekly

The Nasdaq continues to be far less bearish with a stop on Friday at support at 2400. Granted it was a -56 point loss for the day but the loss for the week was only 48 points. For the Nasdaq the 2400 level is the line in the sand that must be defended. Once that level breaks we could see a cascade lower to 2275. If the Dow and the financials continue to be weak the Nasdaq probably will not be able to hold that 2400 level. We have a clear double top at 2550 and this is the second test in the last two weeks of support at 2400. This is a critical test!

The S&P-500 has split the charts between the very bearish Dow and slightly bullish Nasdaq. The index stopped its descent on Friday at 1315 and although under the 1320-1327 some analysts were watching it is still over weak support at 1310 and much stronger support at 1275. The S&P is being pushed lower by the financials with 73 of its 500 components being financial in nature. There is little hope for the S&P as long as the financials continue to weaken. The odds are very good that we will eventually test that 1275 level even if it is not next week.

S&P-500 Chart - Weekly

Like the Nasdaq the Russell continues to find support at higher levels and is struggling to hold on to its gains. 720 is current support and it closed at 725 on Friday.

The Dow Transports were the most bullish index for the week and despite a -98 point loss on Friday the transports actually ended the week higher by +45 points. This is astounding with oil at $135 and is most likely helped by the positive earnings guidance from YRWC earlier in the month. It was definitely not due to the FedEx disaster on Wednesday where they dropped -$5 on earnings news. It had to be the rebound in the airlines pushing it higher. You may recall that the airlines closed at their multi-week lows last Friday and then rebounded on announcements about cuts in capacity, fare increases and a couple dollar drop in oil prices. This is a false rebound and any day the market is open is a good day to sell airline stocks. Earnings estimates for the top 10 U.S. airlines for 2008 are for a loss of $10 billion and growing.

Dow Transports Chart - Weekly

Airline Index - XAL - Chart - Weekly

For next week look for an oversold bounce and undue consternation around the Fed announcement. Volume is going to continue to slow as we approach July 4th and after Wednesday's Fed announcement the volatility should shrink dramatically. Plan your trades carefully and trade your plan. Emotional trading is an expensive hobby.

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:
http://www.aspo-usa.org/aspousa4/

Jim Brown
 

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