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Market Wrap

Banking Surprise

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Never underestimate the power of short covering. The financial stocks exploded out of a major low on better than expected earnings from several large banks, a lack of new bad news and a government bailout for Fannie and Freddie. One analyst called the bank rebound the biggest government backed short squeeze in history. The rebound in financials powered the broader market to gains of 1% to 3% for the week despite major earnings disappointments in the Nasdaq.

Wilshire-5000 Broad Market Index Chart - Daily

Economics were not a problem on Friday and apparently neither was option expiration. It was a calm day and there was no real attempt to sell off the gains for the week. It was a bullish day despite the implosion in the Nasdaq. The main reasons for the Nasdaq drop were Google, Microsoft and Apple.

It was extremely interesting to see traders ignore the rampant +4.9% inflation in the Consumer Price Index (CPI). The annualized headline rate is even higher at +7.9% although the core rate is only 2.4%. Energy continued to be a major component to the rising inflation and it has not changed just because oil fell -$17 from the highs for the week. $129 oil will continue to push prices higher and odds are good it won't stay at $129 for long.

The rising inflation did elicit bearish comments from some Fed officials and the Fed Funds Futures rose to a 62.2% chance of a rate hike at the August 5th meeting. Minneapolis Fed President Gary Stern told Bloomberg on Friday that "headline inflation is clearly too high and could feed through to core prices." Duh, no kidding. He said the Fed could not wait for the economy to stabilize before raising rates. He is a voting member of the FOMC. Former St. Louis Fed President William Poole warned that the Fed should act "sooner rather than later" to begin tightening interest rates. Poole said it would be better to take "a milder hit now in order to reduce the risk of a much bigger hit later." Poole stressed that we are running a "substantial risk" of inflation being more difficult next year. He also said the current data does not justify that we are in a recession. Kansas Fed President Thomas Hoenig also made some bearish comments after touring a manufacturing business in Colorado where every single component had risen sharply over the last year. Hoenig said it reinforced his concerns about needed action to combat inflation. It looks like we are definitely going to see a rate hike when the Fed meets again in two weeks.

The economic calendar for next week is rather light without any major reports. The Fed Beige Book on Wednesday afternoon is likely to be the most volatile event of the week for economics. Everything else is just a repeat of recent data and should be no surprise. We can also expect the Fed heads to be making frequent trips to the podium to warn us a rate hike is coming.

Economic Calendar

Friday was an interesting day in the markets and even more so since it was option expiration. The deluge of ugly earnings reports on Thursday sent the indexes down at the open but only the major techs stayed down. Google (GOOG) lost -$52 and closed at 481.50 after disappointing on revenue spoiled the party. Google lost -10% for it's biggest percentage loss ever. Google said the slowing economy had people clicking fewer ads and that should be a clear sign that the consumer is in trouble.

Microsoft (MSFT) fell -$1.88 or -6.8% for it's worst loss in two years after giving weak guidance about its software sales. Microsoft said spending would be higher but revenues would be lower. Acceptance of the Vista operating system continues to be slow and many companies are now planning to wait for the next Windows release before making any changes. That would be Windows 7 in 2010.

AMD posted a loss of $1.19 billion or -1.96 per share compared to a loss of $600 million in the comparison quarter. That was well over analyst's estimates for a loss of 52 cents. Revenue was also light. AMD lost -13% but at its sub $5 level that only amounted to -67 cents. Intel just needs to give AMD a monthly allowance to give the appearance there is competition in the space. Intel is so far ahead of AMD they may never catch up.


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ValueClick (VCLK) appears headed for zero with a continued drop after warning economic weakness would cause it to miss estimates. Several brokers downgraded the stock to a hold from a buy. The stock is down -50% in the last 8 weeks to close at $10 so those brokers are a little behind the curve.

Overstock.com (OSTK) was beaten like a rented mule on Friday with a -41% drop to close at $16.31. The company said it lost 28-cents per share in Q2 and its marketing costs rose +79% in the same period. Stifel Nicolaus downgraded the stock to a sell saying revenue growth could drop sharply now that OSTK has moved away from selling excess goods and into traditional retail merchandise. The analyst said OSTK may never raise margins above 2-3% at scale and well below Amazon's 8%. I dislike Overstock and will never buy from them again. They cut the return addresses off their packages and don't include invoices. If you want to send something back it is nearly impossible. Customer service is nearly non-existent. Lastly CEO Patrick Byrne has taken to spamming his customer lists with complaints about short sellers crushing his stock. What Patrick does not understand is he needs a real business model and it would help if he actually turned a profit and those short the stock would actually help push it higher in their surprise. He has been on a tirade over shorts for the last couple years in the media but resorting to spamming his customer lists is inexcusable.

Apple Chart - Daily

Apple (AAPL) crashed back to support at $165 on Friday with a -$6.66 loss ahead of earnings on Monday. Apple is expected to post strong earnings despite the recent flurry of high profile disappointments. However, their recent sales success of the 3G iPhone will not count in this earnings report. That will hit next quarter. Apple is expecting to earn about $1 per share on revenue of $7.2 billion for Q2. Analysts are a bit more optimistic with expectations for $1.08 and revenue of $7.34 billion. A problem for Apple was the decline in iPhone inventory in Q2. Since they new the 3G phone was going to be released they let their existing inventory sell down to nearly zero many weeks ago. Many stores had not had any phones for weeks or only a trickle of new inventory being shifted from other regions. How much this impacted iPhone sales is unknown. On the flip side the sales of Macintosh computers are soaring with some estimates of a 33% increase in the quarter. Apple's success with the iPhone is a strong advertising point for the simplicity of the Mac. Piper Jaffray rates Apple a buy with a price target of $250.

Qualcomm (QCOM) is an unexpected beneficiary from the surge in 3G iPhones. QCOM licenses the technology to every 3G manufacturer except Nokia and they are in a nasty royalty suit against them as well. With the popularity of the iPhones it will cause more 3G phones by other makers to be sold as well. Qualcomm confirmed last week that the average selling price of smart phones would climb from their last $203 estimate to more than $217 by year end. Qualcomm also has a new Snapdragon processor that will power two classes of devices from pocket PCs with 4-7 inch screens to mobile computing devices with 7-10 inch screens. Think oversized iPhones on one end and small laptops on the other. Intel has a competing chip but it requires four times power of the SnapDragon. QCOM earnings are on Wednesday.

IBM Chart - Daily

Outside the financial sector IBM was the earnings hero for the week. IBM posted a 22% rise in profits and well over street estimates. They also raised their guidance for 2008 to $8.75 per share, a gain of 25 cents over prior guidance. They earned $1.98 for the second quarter compared to $1.55 in the comparison quarter. More than half of IBM's gains came from their services component. It appears nearly immune to the current economic downturn. IBM said it was concerned about the weak global economy but their current guidance upgrade accounted for that. In other words, times are tough but we are still increasing our earnings. When economic conditions improve they are going to knock the cover off the ball. IBM closed at $129.89 with a gain of +3.37. However, if IBM was given Google's forward PE of 24X they would be a $210 stock. Using Google's price to sales ratio of 6.8x rather than their current 1.6x they would be a $525 stock. Personally I think IBM is a much better company than Google but they are hindered by being an old-line blue chip bought by value funds rather than aggressive portfolio managers. I think we will see IBM at $200 not long after Apple hits $225. Quality growth has a place in today's questionable environment.

Fannie and Freddie have gotten so much press this week I am going to pass on spending too much time on them. Investors feel the Fed will backstop them in some form and guarantee the debt but that is where the feeling ends. Freddie is contemplating selling $5 to $10 billion in equity to avoid additional government oversight. One analyst questions this concept. Freddie is currently yielding 13% on their preferred stock. For them to basically pay 13% for money and turn around and lend it on 7% mortgages does not make any sense. Many analysts feel there is still more rocks in the road ahead for Fannie and Freddie.

Wells Fargo (WFC) was the turning point for the financial sector on Wednesday. WFC beat the street and raised its dividend at a time that others are cutting them. WFC has a large mortgage component and their great results were a serious shock to the sector. WFC posted earnings that fell -22% on higher loan losses but still beat the street. Wells Fargo stock surged +35% to close at $28 on Friday. Their results helped several other major banks gain even more ground after their own earnings. Even Citigroup and their less than exciting earnings on Friday saw a +21% gain for the week.

You know from my prior commentary that the financials were locked in a downward spiral with an all time low on the XLF on Tuesday. The implied government backing of Fannie and Freddie, the elimination of the naked short capability and the earnings surprise from Wells Fargo started a short covering sprint that was nothing short of amazing. The XLF rebounded +25% from its low to Friday's high. The $64 question is will it stick? There is no doubt this was short covering and some asset allocation moves from commodities back into equities. There is a considerable debate underway on whether this rebound has legs or will we roll over again. There are several regional banks that report earnings next week that could upset this euphoria. Wachovia reports on Tuesday and the pessimism is very high. Washington Mutual also reports on Tuesday and their subprime credit portfolio could be a strong negative.

Also reporting next week is Yahoo on Tuesday and Carl Icahn received a blow to his board election campaign on Friday when Legg Mason Capital said it would back Yahoo instead of Icahn. Legg Mason owns 4% of Yahoo stock. It is not a large position but the defection of a high profile play to Yahoo's side is sure to rock some conviction by other large holders. They are the largest independent shareholder to announce in favor of Yahoo. Legg Mason Chairman Miller said he met several times with Jerry Yang before making the decision. Miller feels Yahoo should not be sold for less than $33 and Icahn cannot get that from Microsoft. Icahn owns a 5% stake. According to Yahoo they have 14% of the major shareholders on their side of course Yang and co-founder David Filo have 10% between them so that completes the 14%. Yahoo's earnings on Tuesday could also impact votes. If Yahoo disappoints it would help Icahn garner the necessary votes. If Yahoo somehow pulls a rabbit out of the hat with some miraculous performance that could help Yang garner votes. Yahoo has taken the fight to their webpage with a big banner poking fun at Icahn and a link to a page with all the reasons shareholders should back Yahoo. On that page is a list of companies Icahn has attacked/joined and the results in the stock price after that involvement. The list appears to be rather damning but I don't know how it was produced other than you can bet it was biased. The list would not make me want to vote for Icahn so I guess it served Yahoo's purpose.

Unless you live in a cave you probably heard about the $17 drop in oil prices from Tuesday's high of nearly $147. Crude closed at $128.88 on Friday for the biggest weekly drop in history. Various support levels were crushed and Friday's close suggests a possible test of $122 on a purely technical basis. The reasons for the drop were as varied as there were investors but several stood out specifically. Options on crude futures expired on Thursday. August crude futures themselves cease trading on Tuesday. Oil was grossly overextended with a nice double top at $147. Demand is dropping almost daily. There were a dozen reasons why crude could have dropped but expiration and an asset swap back into equities were probably the most important. Another prominent reason was the "apparent" cooling of Iranian tensions. On Tuesday comments were being made about a meeting with Iran's nuclear negotiator this weekend. An Iranian spokesman denied it saying it was "psychological warfare." On Wednesday they admitted they were meeting with the UN group in Geneva. On Thursday the U.S. said they were sending an official envoy, William Burns. This will be the first official meeting between the U.S. and Iran since the hostage crisis in 1979. On Friday Condoleezza Rice said the U.S. has no "permanent enemies" and is open to negotiations with anyone. She said Iran was "a difficult and dangerous state" but "We have been very clear that any country can change course." Many analysts have claimed over the past months that the growing tensions between the Israel, Iran and the U.S. were responsible for as much as $40 in the price of oil. Unbelievably, the U.S. also suggested it might consider opening a diplomatic mission in Tehran. I can't even believe the words I just typed given the rhetoric of the past several weeks.

August Crude Oil Futures Chart - Daily

While all of this may seem like Iran is just going to walk in and layout their nuclear plans to be blessed by the participants this is not the case. On Thursday Iran has made broad claims about the meeting in an effort to boost their credibility in the Middle Eastern region. The great satan has come to bow at our feet or something like that. The press has been eating this up and oil prices were falling like a rock. Now as of late Friday night Iran has changed its tune. They will not allow any influence by the Zionist state, referring to Israel. No power on earth can deny us of our nuclear rights. And, the combined proposal from the six nations (China, Russia, France, Britain, Germany and U.S.) is not acceptable. They basked in the glow of U.S. recognition late in the week and now appear prepared to disagree with everything. Analysts believed nothing will come from this meeting because Iran hopes to find a more agreeable ear when a new president is elected. This is just a stalling tactic on the side if Iran and a desperation move on the U.S. side in hoping to get something done before Bush leaves office. I believe the meeting was destined to fail and next week Iran will be as forceful as always in claiming its nuclear right. The six nation U.N. group will try to enact stronger sanctions in order to get something done before Israel does something stupid. To the extent any Iran premium was subtracted from oil prices in advance of the meeting they could rebound just as easily. After meeting for six hours on Saturday the diplomats said they were still deadlocked on Iran's refusal to halt their nuclear program. The six countries said after the meeting "Iran has been given two more weeks to give us a clear decision or face stronger sanctions. The U.S. State Dept said, "Iran has been given a choice to make: negotiation or further isolation." The British official said, "They can take our warning back with them to Iran but if they don't agree with the proposals, we will have to start imposing sanctions." It does not appear to me that it went well for Iran.

You may remember a week ago when Iran showed pictures of a missile test with four missiles streaking skyward out of the desert. A couple days later that picture was pulled and replaced with one with three missiles streaking and one dud still on the trailer. They had modified the original to erase the dud but got caught. A reader claims that was still not the correct picture and sent me a copy of the actual missile shoot. (grin)

Iranian Missile Test

Last Tuesday I showed a table of the comparison of the January 22nd market bottom and the internals on Tuesday. I updated the table and you can see below that the volume reversed after the opening drop on Wednesday to sharply overpower the declining shares. Volume was strong with a strong imbalance. This was a perfect example of a short covering rebound. Volume slowed on Friday even though it was option expiration. That suggests that either the short covering has run its course or traders were just leery of buying the steep bounce ahead of the weekend. I vote for both.

Market Internals

I reported in past commentaries that a bear market typically has at least two 5% rebounds and one rebound of as much as 8-10%. The Dow rebounded +6% off its Tuesday lows and the S&P +5%. Technically we have fulfilled the criteria for a bear market bounce. Can we go higher? Absolutely. The Dow could easily run to 11700 and a Fibonacci retracement of 38% from the May high to the July low. That would also be an 8% rebound. Nobody can tell you with any certainty if that will happen or not but it is always possible.

The only thing we can be sure of is continued weakness in the banking sector. Their problems did not go away just because a couple banks had less than catastrophic results. Despite the government backed short squeeze the economy is still in the tank and sentiment is still falling. Fuel prices are still going to be pushing inflation higher even if oil falls to $122. The Fed is going to raise rates at the August 5th meeting and they will have to talk tough on inflation for the hike to have any impact. August and September are the two worst months of the year for the markets with bottoms normally made in October. The presidential candidates will be calling names and telling us how bad it is for the next two months as they position themselves ahead of their conventions. This is always bad for sentiment. September is known as cleanup month because fund managers clean house after the Labor Day holiday in preparation for buying October bottoms.

Just because the next two months are typically bearish and we are already in a bear market does not mean it will continue. It does not mean we will just rocket higher either. The focus for next week will be more earnings and especially the regional banks. The earnings scorecard will be helped by a lot of energy companies reporting. Analysts still claim oil companies are valued at $80 oil and we have not been there in a long time and I doubt we will ever be there again. That suggests the energy sector still has room to grow. With the oil implosion last week this could be a good entry point for some oil plays.

Dow Chart - Daily

The Dow closed above resistance at 11400 and could run to 11700 as I indicated above. Support levels are 11200 and 11000. The Nasdaq has resistance at 2325 and closed at 2283 after the Google/Apple/Microsoft decline. Support is 2200. There will be a flurry of semiconductor stocks reporting next week including TXN and QCOM. Good news could overcome the negative big tech sentiment and bad news could add to it. According to one analyst somebody bought 140,000 QQQQ Sept-$42 puts on Friday with the QQQQ at $44.50. Having a lot of money does not make you right but it is interesting to note that people are making big bets. I believe this is probably a portfolio protection play rather than a bet the QQQQ is going lower.

Nasdaq Chart - Daily

S&P-500 Chart - Daily

The S&P recovered to resistance at 1260 and stalled. The rebound was completely driven by financial stocks and it will be up to that trend to continue if the S&P is going higher. There are several resistance levels on the S&P at 1275 and 1285 and just getting over the 1260 hurdle won't give them a lot of room to run.

I cautioned everyone last week about the potential for a short covering bounce and not to get married to it. Trade it but don't back up the truck thinking the only direction is up. Now that we have had a 6% rebound it is time to start looking for a failure. Hopefully it won't happen but if you are watching for it you won't get hurt. Next week should be interesting regardless of which direction the markets move.

Jim Brown

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