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Market Wrap

Earnings Surprise

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For a quarter that was supposed to be very negative in terms of earnings the outcome has been significantly different. With 66% of the Dow already reported, 70% of those beat the street. Over 45% of the S&P has reported and 75% beat the street. The historical average is for a 61% beat. That seems rather bullish if you stop there in your analysis. Unfortunately the best earners are the blue chips that report first and earnings quality declines as the cycle progresses. Secondly the earnings fell -17.8% for the quarter. If you exclude energy companies those earnings then decline by -25.8% for the quarter. Lastly the financial sector was expected to produce an earnings decline of -60% but instead have reported a -90% decline. Guidance has also been worse than normal with an almost unanimous view across all sectors that Q3 and Q4 will see lower profits. It is not surprising that the rebounded faded as the week progressed.

Wilshire 5000 Broad Market Index Chart - Daily

Dow Chart showing Doji Star Reversal

Friday was a good day for economics with three big surprises. The Durable Goods report for June rose by +0.8% when analysts were expecting a decline of -0.7%. Were it not for a sharp drop in aircraft orders the headline number would have been around +2.0%. That would have been the largest monthly increase this year. This was the second month of positive growth. Unfilled orders also rose and the orders to shipments ratio is near its all time high. The inventory to shipments ratio is at its highest level since 2001. This was a very positive surprise.

The Consumer Sentiment for July spiked to 61.2 from June's 56.4 reading. This was the first move higher since January. Analysts credited the tax rebate checks and a firming of home prices in many states. A reading of 61 is hardly something to be bullish about but it was a far cry from the expectations for something in the low 50s. Current conditions rose +6 points to 73.1 and expectations rose +4 points to 53.5. Inflation expectations remained high at 5.1% but appear to have eased somewhat from the first July reading at 5.3%.

Consumer Sentiment

The third report for the day was the New Home Sales for June. New sales totaled 530,000 units and much better than the 501,000 analysts expected and better than the previously reported 512,000 in May. However, the Census Bureau revised the May numbers up to 530,000 as well as the April numbers to 540,000 from 520,000. This surprising improvement in sales was good news to everyone. New home prices rose slightly to $237,871 from $231,087 in May for a +2.94% gain. Months of inventory decreased slightly to 10.0 from 10.4. Sales in the second quarter declined only 17% over Q1 compared to drops of nearly 40% in the prior three quarters. Homebuilders claim the limited access to mortgage loans is the biggest drag on sales today. As long as Fannie and Freddie continue to take mortgage paper that will eventually ease but the biggest problem then will be the down payment. Gone are the days of little or no down and saving has never been an American blue-collar tradition.


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The report calendar for next week is very light until Thursday. The last two days of the week make up for a slim list the first three days. The GDP will be the big report on Thursday with expectations for 2.15% growth in the second quarter. If the real number is anywhere close to that it would appear the country has dodged the recession bullet. Q1 growth remained positive even if only barely at +0.96%. The Chicago PMI will be seen as a preview of the ISM on Friday. These are both indicators of current economic activity. The non-farm payrolls on Friday will be a critical test of the current economic strength. Current estimates are still for minimal job losses of 70,000 jobs compared to normal recession losses of 250,000 to 400,000 per month. If job losses remain muted it would be a good sign the economic indigestion is easing. However, we saw a sharp spike in unemployment claims last week at 406,000 suggesting job weakness was increasing. There can be a lot of noise in the weekly numbers and one week does not make a trend. The payroll report will be the most important report of the week.

Economic Calendar

The keys to market direction next week will still be earnings with nearly 750 companies reporting. This will be the heaviest week of the Q2 cycle although most of the largest companies have already reported. Earnings quality will continue to decline as we move farther into the cycle. This will be a heavy week for energy earnings and those should be very strong.

Earnings Calendar

Late Friday afternoon Chrysler shocked the markets saying they would no longer write leases on its vehicles. This is shocking for more than one reason. Chrysler depends on leases for nearly 20% of its sales. Analysts were shocked that they would risk pushing that many buyers to Ford or GM. Many people, especially small business owners, lease their vehicles so they can deduct them from their taxes. That is not likely to change just because Chrysler is no longer writing leases. Those customers will go elsewhere to shop. Chrysler said the business was changing, they could no longer be competitive in leasing and the cost of capital would be better utilized elsewhere. Chrysler said its $30 billion credit facility is up for renewal in August and borrowing costs were going to rise given the continuing credit market turmoil. In reality analysts believe it is the falling residual values of their vehicles that caused the problem. Chrysler sales are off -22% year-to-date and Chrysler said they expected the decision would cost them additional sales. It probably won't be the entire 20% of their lease sales but it could be close.

Chrysler had the heaviest mix of trucks/SUVs at 75% and the residual values of those products have fallen through the floor. In a lease the company typically assumes a 40% residual on a three-year lease. With used SUV values off 50% in most areas from just a year ago those residual values are underwater and not expected to recover. The consumer is also dumping debt at every turn. Auto loans/leases have been said to be the next housing crisis. If people are going to let their homes be foreclosed then keeping a lease car is not going to be a priority. Ford just took a $2.1 billion charge for its finance company when it reported Q2 results. That was in large part because of the hit it took on the declining value of SUV and truck leases. Nissan CEO Carlos Ghosn said this week that rising reserves needed to cover losses on vehicle leases had been one major surprise in the downturn for Nissan.

America is finally shifting to an economy focus and it would take a drastic change in the price of oil to make them reverse again. OPEC has always worried about changes in driving habits because they view it as a decade long move. In the past major changes in driving habits took years to reverse simply because of the replacement cycle. It takes years for automakers to switch vehicle types and then years for them to switch back when the crisis is over. They can't design and retool overnight.

Chart of GM - Daily

Trucking company YRC Worldwide (YRCW) reported profits that fell -35% and blamed the decline on the struggling economy. No surprise here and CEO Bill Zollars has been up front about the worsening conditions for months. On Friday Bill said on CNBC that they were seeing signs of life in the economy. He said sizes of shipments were increasing, as were numbers of shipments. He said it was too early to start calling a bottom but the signs were encouraging. Given his early warning on the economic decline this is a positive sign even if it is in the early stages of the change.

GE announced this week it was restructuring into four business units, down from six. This is in addition to their announced plans to spin off its lighting and appliance businesses. They could not find any buyers so they are going to donate it to the shareholders. The new units will be GE Technology Infrastructure, GE Energy Infrastructure, GE Capital and NBC Universal. GE Money is still for sale but no takers there either. Earlier in the week GE announced a joint venture with Abu Dhabi where Mubadala Development will pump $4 billion in outside capital into GE's commercial finance business. All these announcements follow a surprise earnings miss by GE last week.

S&P place Fannie and Freddie on negative credit watch as the stress level increases on those companies. S&P said it expects the stress to continue and placing them on credit watch is a pretty good indicator they will change the rating soon. With mortgages failing in record numbers Fannie has already raised $7 billion in capital and Freddie $5.5 billion. The government has pledged to help them and the Fed said it would open a special lending option to provide further support. Congress is expected to pass the housing bill this weekend and that includes guarantees of up to $100 billion for the pair. Lawmakers said there was only a 5% chance the companies would need the support and the maximum risk to the taxpayer was $25 billion. Over the last year the government along with Fannie and Freddie have already put $1.43 billion of support into the mortgage market. That breaks down as Fed $446B, FHLB $274B, FHA $90B and F/F $621B. As a result of the subprime crisis banks have already written off $880 billion and expectations are for that to climb to $1.5 trillion by the end of 2009.

In a side note the Fed reported that bank borrowings at the discount window rose to an average of $16.38 billion per day in the latest week and that was the highest level ever. This does not bode well for the health of the sector. If you are a bank today you are basically a ward of the state. You can't raise money in the equity market and banks are not lending to each other for fear of skeletons in the closets. This suggests the economy is not going to have a growth spurt any time soon.

The Fed seized two more banks after the close on Friday and immediately sold them to Mutual of Omaha Bank. The two failing banks were the First National Bank of Nevada with assets of $3.4 billion and $3 billion in deposits. The bank just completed a merger of its own with the First National Bank of Arizona on June 30th. Bet those stockholders are happy today. The second was First Heritage with assets of $254 million and $233 million in deposits. The FDIC said the estimated cost of the transactions to its insurance reserve account would be $862 million. The 28 branch banks will reopen on Monday as Mutual of Omaha Bank. Mutual itself only has $750 million in assets and operates 14 branch locations. Thanks to good management and a strong balance sheet it was able to quadruple its size overnight. However, it is also a subsidiary of Mutual of Omaha, a 99-year-old insurance company with $19 billion in assets. It never hurts to have a rich parent.

Juniper (JNPR) was a double winner this week reporting earnings that jumped +40% on stronger sales of networking gear and a new CEO they stole from Microsoft. Kevin Johnson will take the reins on Sept 1st. Juniper jumped +$4 on Friday after reporting profits that jumped from $86.2 million to $120.4 million. Revenue was also up more than $200 million to $879 million. It was a great quarter for Juniper and Friday's spike came off a two-month base at $22.

On the flip side Crocs (CROX) was crushed for a 45% drop on Friday after slashing their outlook after Thursday's close. One analyst called Crocs an endangered species after months of warnings on sales and the final blow on Thursday. CROX said in May that earnings would be in the 42-47 cents range for Q2. Thursday night they slashed that guidance saying they only expected to make 3-7 cents now. They blamed the challenging conditions in the domestic market place for the drop in sales and by the way overseas markets were weak as well. Let's see, that sounds like "the economy killed us" excuse but they blew their credibility when they added the sentence about the weak overseas sales. What killed them is the generic competition from a dozen companies. You can get Crocs look-alikes at Wal-Mart for $5-$8 and nobody will ever know the difference. CROX closed at $4.93 on Friday. I hope everyone who owned it at $75 last Halloween saw the warning signs and bailed.

CROX Chart - Daily

Qualcomm (QCOM) also won twice last week. One when they settled the patent dispute with Nokia and the second time when they won the S&P-100 lottery. QCOM was named to replace Clear Channel (CCU) in the S&P-100 after Friday's close. Qualcomm announced a settlement on Thursday in the CDMA squabble with Nokia. Nokia agreed to a 15-year royalty deal in order to get back into the U.S. market with 3G CDMA phones. They had been blocked from selling those phones in the U.S. after they lost a court battle last year.

NetFlix (NFLX) beat the street by 2-cents on Friday and said it added 168,000 subscribers over the quarter. In the same quarter in 2007 they lost 55,000 subscribers. NetFlix said they appeared to be unaffected by the slowing economy probably because families were spending more time at home in front of the TV rather than burn gasoline going places. NetFlix said it was finding a large acceptance of its streaming movie service with over 100,000 of the $100 devices sold in the first two months of service. Microsoft's Xbox is scheduled to begin streaming for NetFlix this fall and that could increase subscribers by leaps and bounds. Blockbuster is preparing to hit the market hard with the service it acquired from Movielink last year but it appears NetFlix is still sprinting ahead. Too bad their stock is not sprinting higher. When they start adding streaming subscribers by the millions through the Xbox that should change. I tried to find a total for the number of Xboxes in circulation but after topping 30 million in 2007 I could not get any more current numbers. Microsoft expects to sell 6-8 million in 2008. That should be a very good market for NetFlix.

Oil prices shook off a rebound to $126.50 overnight to close at $123.26 on Friday. The decline that began on July 15th is continuing but $122 should be fairly strong support. The next week will be a make or break week for the energy sector. A move under $120 would produce heavy technical selling while a rebound could trigger some serious short covering. Factors that could impact oil include a new tropical disturbance forming well east of the Caribbean but moving westward at 15-20 mph.

September Crude Oil Chart - Daily

Violence flared again in Nigeria and rebels kidnapped eight oil workers in three separate incidents according to reports out late Friday. Eleven Russians and a Ukranian were seized from a vessel off the island of Bonny but six were released. Five are still being held. The vessel was working for an Italian oilfield company. No demands have yet been made by the kidnappers. Security services said an oil services vessel was attacked on its way to a field operated by Total but there was no word on causalities. The MEND rebels warned two weeks ago they were ending their truce after Britain told the Nigerian government they would help to rid the country of its violence. It appears the MEND rebels are making sure the Nigerian government is aware they are back in action. Repeated attacks on this scale will force production to slow again. MEND rebels have promised to blow up the major pipelines in Nigeria within 30 days to prove they are not being paid off by the government in a $12 million bribe as various news stories have claimed.

Russian markets have been in a tailspin over the last week after Putin made negative comments about OAO shareholder Igor Zyuzin. His implied threat of physical violence after Zyuzin failed to attend a meeting sent the markets into free fall. Putin is attacking nearly every major company much like Hugo Chavez recently did in Venezuela. Renaissance Capital strategist said the idea of Russia as a safe haven is finished. Investors fear worse purges and takeovers ahead as the government tries to combat 15% inflation and the perceived flight of money out of Russia. The Russian markets fell -20% last week. The CEO of TNK-BP, the joint venture of BP and AAR, was refused a visa last week to continue working in Russia. The government is trying to run BP out of the partnership and give control to Rosneft. All of the problems in Russia are slowing production with the first serious declines in a decade. There is plenty of news impacting oil all over the globe and that suggests support at $122 should hold.

The Senate failed to get enough votes to pass the oil speculation bill. They were only able to garner 50 of the needed 60 votes to pass the resolution. Among other things the bill would have closed a loophole that allows speculators trading on the London oil market to escape scrutiny by U.S. regulators. The Intercontinental Exchange (ICE), which owns the London based derivatives exchange rallied +13% on the news.

Final approval came on Friday for the XM Satellite and Sirius Satellite merger. The FCC vote was 3-2 with Republican commissioner Deborah Tate making the tiebreaker vote. Tate had insisted the pair settle charges they violated FCC rules before she would approve the deal. The companies finally agreed to pay $19.7 million to the U.S. Treasury for violations related to radio receivers and ground based signal repeaters. Subscribers will be able to listen to content from both providers but they will have to buy new dual channel radios to receive content from both companies. The combined companies had to agree to a 3-year price cap and to provide 8% of their programming as full time audio channels for public interest and minority programming. They will also have to adopt an open radio standard that could lead to greater competition among manufacturers. They also have to offer a limited a la carte offering that would be available within three months of the close and allow listeners to pay only for the channels they want to receive. I am just glad the 16-month deal is finally completed so I don't have to listen the constant debates about it.

This was a confusing week for me. We had the buy program on Tuesday at the close that pushed the indexes over their strong resistance points but the follow through on Wednesday was lackluster at best. The -283 point sell off on Thursday brought back fears of another leg down but Friday's lack of selling rekindled hope for the bulls. You may remember I changed to cautiously bullish after Tuesday's tentative breakout and suggested we switch to buy the dip mode. I also posted a chart of the Dow showing the potential failure points including the Fibonacci retracement level at 11700. On Wednesday the Dow rallied to 11698 and failed almost instantly. It was a perfectly scripted touch and failure at strong resistance. Unfortunately I did not script the sell off in the financial sector on Thursday that knocked the indexes back to support. I would have preferred a slightly less severe dip to buy.

Dow Chart showing Fib Resistance Levels

The Dow closed positive on Friday but it was a fight that it almost lost. IBM, BAC and GM were the biggest losers. For reference the five financial stocks in the Dow accounted for nearly 100 of the -283 points the Dow lost on Thursday. Support is currently 11200 but I definitely hope we don't have to test that level. I previously discussed the potential for 5-8% rebound rallies in a bear market and even as much as 10% in some. I had thought that we were going to avoid another leg down on Tuesday but now I am not so sure. I am not changing my buy the dip view as long as the Nasdaq and Russell remain the strongest indexes. The Dow is handicapped by its financial components, as is the S&P. I am going to caution that the internals appeared to be breaking down late in the week. I don't think we can call Thursday anything but ugly and 5:1 declining over advancing volume is not just profit taking. It was fears the credit crunch was coming back to haunt us again. News of record discount window borrowing and two more failed banks is only going to increase those fears.

The Nasdaq rallied +30 points on Friday and moved right up to solid resistance at 2310. This is a bullish chart even after the drops in AAPL, RIMM, GOOG and company. Even those stocks have started to recover. The Nasdaq is not impacted by the financial crisis except from the drag on the markets by the Dow and S&P. Investors appear to have shaken off the gloom and doom in the chip sector and we could be seeing some of the money that rotated into financials the prior week rotating into techs now. Initial support is 2270, resistance 2310-2325. A break over 2325 should attract additional buyers.

Nasdaq Chart - Daily

S&P-500 Chart - Daily

S&P-500 Chart - 60 min

The S&P-500 failed miserably at 1290 on Wednesday and dropped back under 1260 at the close on Friday. It was not a pretty sight. Obviously this is because of the drag by financials and because the drop in oil tanked energy stocks and the second largest S&P sector. I am worried about the S&P dragging the Nasdaq into the tank with it. It looks weak and could be very close to a breakdown. I know this conflicts with statements I made above but there is some tremendous divergence among the indexes today.

The Russell 2000 declined only slightly from the Wednesday highs and remained well above prior resistance at 700. As long as the Russell is showing strength we need to buy the dips in the broader market. The Russell continues to exhibit better relative strength than the rest of the market. Fund managers are buying small caps and that is long term bullish.

Russell 2000 Chart - 180 Min

For next week we have month end on Thursday and that could see some window dressing but the reports on Thursday and Friday are going to be critical. They should supply an upward bias because all the bad news for the next couple months is already priced into the market. The Fed meeting the following Tuesday already has a quarter point rate hike priced into the announcement so any talk about not hiking would be bullish. Personally I don't expect any with FOMC members Fisher, Plosser and Stern already calling for a hike. The Fed needs to hike to support the dollar and begin fighting inflation and I believe that will be seen as a positive move. It also suggests the Fed believes the economy is no longer on life support. However, we did get testimony from Bernanke just over a week ago that the Fed thought economic weakness was a bigger problem than inflation so it may come down to a coin flip when they take the vote. We still have another week for that discussion to heat up before the markets have to start taking a position.

A big event for Monday could be the housing bill. The support for Fannie and Freddie could imply that existing shareholders are eventually going to be diluted away and the drops on Friday ahead of the weekend vote suggests traders are also worried current equity holders are going to get hammered. This could continue to pressure the financial community in general because we are hearing the same song about the rest of the banks in trouble. More equity being sold just to survive dilutes existing holders. Banks are not done going down if you believe most analysts despite last week's short covering rally. To summarize all my market views I would continue to buy dips above 690 on the Russell. Under 690 I would be short or flat. Despite being cautiously bullish we have to expect the unexpected. We are approaching the two worst months of the year for the markets (Aug/Sep) and anything is possible.

Jim Brown

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