Option Investor
Market Wrap

Dramamine Please

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I am getting seasick on all these market waves. Dropping 200 one day and rising 300 the next reminds me of suffering through 12 hours of 12-15 foot waves on a fishing trip I once took. Traders are getting whipsawed left and right with stops being crushed on both sides of the market. Bears are getting hammered one day and bulls the next. Fortunately Friday's breakout suggests a new trend is taking shape.

Wilshire-5000 Composite Index Chart - Daily

Friday was a lackluster day for economic reports. The Productivity and Costs report for Q2 was worse than expected on productivity but better than expected on costs. Nonfarm productivity rose +2.2% compared to expectations for a 2.8% gain. Unit labor costs rose only 1.3% compared to expectations for a 2.7% gain. These numbers are lagging indicators but do suggest that inflation pressures are easing and that will be good news for the Fed. Wholesale trade numbers for June showed inventory levels rose 1.1% and sales +2.8%. This compared to expectations of 0.8% and 2.2% respectively. This is also a seriously lagging report nearly 45 days after the period surveyed. The markets rarely pay any attention to these numbers as anything other than just another brick in the economic foundation. Most of the price increases were attributed to the rise in crude prices so it is hard to get excited about the gains.

The economic calendar for next week is mostly filler. The only moderately interesting reports will be the Consumer Price Index on Thursday and Consumer Sentiment on Friday. There is just nothing on the calendar that will interest the markets.

Economic Calendar

The markets on Friday were influenced by three things. The Citi/UBS settlement on auction rate securities, the continued implosion in oil prices and the strengthening dollar. UBS, Switzerland's largest bank, agreed to buy back $18.6 billion of auction rate debt securities whose value collapsed during the global credit crunch. This followed news on Thursday that Citi and Merrill would buy back almost $20 billion in auction rate debt. The auction rate securities were rated as liquid as cash when they were sold by the major firms. The auction rate market was valued at $330 billion before it collapsed in February. Owners had been unable to access their money since February. Several other banks are said to be under investigation by regulators over this issue. The banks are agreeing to pay substantial fines but the buybacks are not going to be immediate. For instance UBS will buy back $8.3 billion beginning on Oct-31st and the remaining $10.3 billion beginning in June 2010. UBS was under attack by the state of Massachusetts, New York and the SEC. The settlement with these agencies and $150 million fine will cover 80,000 investors. Unfortunately just knowing you will get your money back by 2010 is not the answer. Since these securities were marketed as cash instruments many institutions parked operating funds there because they could get it out with 72 hours notice. If I put my next six months of operating cash in an auction rate security and planned on withdrawing as needed over the next six months and suddenly I could not get access to the funds until 2010 I would be hysterical. This is the problem these investors faced.

The auction rate system broke down in February when several banks who made a market in the daily auction system withdrew their support. Suddenly there were no bidders and 100% sellers. The market was frozen without any market makers and nobody had the cash or the credit lines to step up to the auction window. That is the problem with the settlements and the two-year window for buying back the debt. The major banks simply don't have the cash to buy them back today. Everyone in this debt wants out immediately making it a true run on the banks. The concept behind the auction rate market was a liquid pool of capital paying market rates as decided by a daily auction. It was like a big money market where some companies could sell bonds into the market and others could invest in the bonds on a short-term basis. They could always get their investment back at any time by selling the bonds back into the market in the daily auction. When the buyers disappeared the rates offered by sellers rocket by several hundred percent and companies that needed to finance their operations could no longer afford to sell their bonds into the market. A typical seller would be a city government or university building project trying to capitalize on the low interest rates rather than do a permanent bond offering. Some estimates claim there are more than 500,000 players in this $330 billion market. When it froze it caused a monster capital drain on those players. This settlement is only a portion of the outstanding debt but a big step in the right direction. Banks hope that once the market starts trading again it will loosen up and return to its prior cash-liquidity status. Unfortunately it will not happen until the major banks are able to again make a market in these securities. Without cash and credit lines it will be nearly impossible for quite sometime.

The market took these settlements as evidence the credit crunch is beginning to ease. Granted it is a small step but one problem that had been hanging like a guillotine over the sector. With these major banks initiating the settlement process the smaller players will probably see the light and do the same. That gave the market hope that one more credit cloud was dissipating.

Oil prices fell -$4.87 to close at $115 and well under prior support. Traders are now convinced we will see $110 tested next week. This drop came despite a major pipeline bombing that took nearly one million barrels per day offline for up to five weeks and an escalation in the war between Russia and Georgia. Russia is the second largest oil producer and there are fears the escalation could pressure supplies from the region. Elsewhere the U.N. group working on the Iran problem said it could be October before a new vote on sanctions could be brought to the U.N. Security Council. That effectively put the Iran problem on the back burner and out of the headlines. The result was a breakdown in support for oil over fears U.S. declines in miles driven will lessen the long-term demand for oil. The EIA said demand in July fell -2.3% over the same period in 2007. Americans are not driving and are altering their consumption habits. However, as we have seen countless times in the past the return of cheap gasoline always increases demand to prior levels. It is only a matter of time. Until that happens the price of oil could continue to weaken with $110 the next major support level. This is exactly what the Fed was hoping for since oil prices were a major contributor to the rising inflation over the last six months. Falling oil prices will slow inflation, reduce costs for businesses and reenergize the global economy.

Crude Oil Chart - Daily

Dollar Index Chart - Daily

Lastly the market was helped by the rise in the dollar. The US Dollar Index has exploded over the last two weeks to a six-month high and that makes commodities including oil significantly cheaper in dollar terms. The change in the dollar is coming at the expense of the Euro. The rapidly declining economic conditions in Europe prove once again that when the U.S. economy sneezes the rest of the world catches cold. The Euro also sank against the Japanese Yen and the British Pound. On Thursday the ECB and the Bank of England left their key rates unchanged at 4.25% and 5% respectively. ECB President Jean-Claude Trichet issued a warning on inflation and said economic numbers for Q2/Q3 would be much weaker than expected. He also indicated a rate hike to fight inflation would probably not be coming. This is in sharp contrast to his statements back on June 5/6th that the ECB was planning to raise rates. That comment sent the dollar plunging and the price of oil up $10 over two days. The sharp rise in the dollar is a game changer for commodities and the balance of trade. A stronger dollar helps in many ways but mostly in lowering the cost of commodities and raw materials for U.S. firms.

All of this good news on one day created yet another short squeeze of monumental proportions. All the major indexes broke out to new six-week highs and it would appear on the surface the bear died. Unfortunately that may not be the case. All major market turning points occur on high volume. Friday's volume was barely over 8 billion shares and definitely not a strong day. That is not to say we did not have a change in market sentiment but that did not translate into a change in the internals.

Part of the underlying factors in Friday's market gain was the normal Friday before options expiration trade. For the last couple years the option expiration fireworks have come on the Friday before expiration rather than expiration day itself. This is the funds rolling out of option positions before the premiums collapse completely and before the next months premiums rise as they become the front month. For the oil sector the options on crude futures expire next Thursday. Anybody who was bullish on crude over the last month was dumping those losing positions Friday.


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In stock news Apple caught new coverage at outperform by Credit Suisse after UBS initiated coverage on Tuesday with a buy. Apple gained +5.94 to cap a four day win streak of +$16 to close at $170. That is the highest level it has reached since earnings disappointed on 7/21 and we saw a low of $146 on 7/22. Personally I think Apple is a screaming buy. I went to the mall on Thursday after the market closed to have my glasses fixed. With an hour wait for the repair I decided to walk the mall and checkout the retail activity. Abercrombie & Fitch (ANF) did not have a single customer in the store and I checked twice over 45 minutes. All the high profile stores were ghost towns with salesmen grouped around the registers like vultures waiting to pounce on the next unlucky person to wander into the store. There was one store that was a huge exception to the rule and that was the Apple store. At 2:30 on a Thursday afternoon there were more than 70 people packing the 35x120 foot store. The activity was frenzied and people were carrying out bags in both hands. They were buying iPhones, iPods, notebook computers and accessories by the bag full. I stepped inside and just stood in the corner watching the frenzied activity. The manager noticed me and came over to ask what I was doing. I commented on Apple being the only store in the mall with customers and he laughed. "This is a slow period. Come back on the weekend and we will have a waiting line outside in the mall. We also have a security guard for crowd control." I know Apple was cautious in their earnings outlook but they are making money by the truckload. I would be a strong buyer of Apple on any pullback. $4 gasoline has not hurt their business the way it has everyone else. I would also be a seller of ANF.

Meanwhile I would also be a buyer of Research in Motion (RIMM). I got a kick out of one group of teenagers I saw in the mall. There were six of them and they were having a heated discussion about the various merits of their phones with three holding Blackberries and three holding iPhones. That should tell you something about the impact of these phones that six 15-17 year old high schoolers all had these phones. The BlackBerry is far from dead and as we have seen in past earnings reports the iPhone success has actually helped the BlackBerry rather than hurt it. By raising the average selling price of a fully featured phone it made the BlackBerry more attractive. With multiple models and plans it is actually cheaper than the iPhone in many cases. Did you ever think you would hear the Blackberry called a cheap phone?

If you just looked at the airlines you would think oil prices had fallen back to $15 a barrel rather than $115. The XAL closed at $25.15 and has risen 100% since hitting a low of $12.66 on July 15th. If you were smart and bought airlines when everyone was planning their eulogy you would have a great trade. Some of the individual airlines have gained more than 100%. Take Continental (CAL) for example with a rally off the $5.91 low to close at $16.48 on Friday. AMR $4.00 to $11.26 is another example along with United (UAUA) from $2.80 to $11.13. I hope the rally continues so I can short the heck out of the XAL the next time oil heads towards $150. The pain relief is only temporary and once peak oil arrives we will see permanent new lows across the board. Until then they would be a trading vehicle and a prime example of how quickly consumer sentiment reverses when oil prices fall. Who knows, next week we could have GM telling us they sold out of new SUVs. The Dow Transports were up +5.4% for the week.

XAL Chart - Weekly

Ford joined the anti-lease club on Friday with an announcement they were going to reduce lease volume by making leases more expensive and shifting incentives to favor purchases. They will reduce the residual value assumptions on the leases, which means the user will have to pay more on the monthly payments. This puts the burden back on the consumer and you can bet it will reduce sales simply because leasing was a cheaper alternative in many cases because the user only had to pay for a couple years of use rather than the full price of the vehicle.

CCountrywide Financial Chart - Weekly

It was a year ago this week that Countrywide Financial began the bprime crisis with a note buried in their 10Q warning that unprecedented credit problems had risen sharply and current liquidity "should be enough" to weather the storm. Obviously that statement proved to be wrong and the mortgage meltdown began. Today Fannie and Freddie are about the only mortgage lenders left in the marketplace but there are signs the housing crisis may be easing. Florida actually reported rising home prices in several areas. Sales on the West Coast are increasing and homebuilder losses are slowing. Obviously we are far from out of the woods but conditions are setting up for a rally in the spring of 2009. That of course assumes we avoid a recession this fall.

The Dow broke out to a new six week high on Friday on a gain of +302 points and +408 for the week. We have a strong pattern of higher lows and it appears the buying interest is increasing. However, if you look back at the March rally the Dow rose for 69 days after the March 10th low before rolling over into a steep decline. Most analysts are giving cautious comments about assuming a new bull market has appeared. They cite the low volume as evidence of low buyer interest. However, August is a low volume month as traders try to squeeze in the rest of their vacations before Labor Day. I would love to see the rally continue and the breakout appears promising but it did start as a short squeeze at the open. Be bullish but be cautious.

DDow Chart - Daily

Thomas Lee an analyst at JP Morgan claims there have been 31 bear markets in the last 100 years. Those that dip to the 20% threshold and then quickly rebound are called cub markets rather than full-grown bears. So far this fits the description of a cub market exactly. Lee says that in the first six months of a rebound out of any bear market the average is a 15% gain in the Dow. Over the first 12 months that stretches to 25%. The key here is determining if the July 15th low is the actual low and therefore the point where the rally began. With unemployment claims mounting and retailers whining about less than expected sales and with another round of bank write-downs still to come there could be another leg down. An 8-10% rebound in a bear market is a common occurrence and Friday's gains took this rebound to 8.2%. Also remember that August and September are the two worst months of the year for the markets. It is not unusual for the markets to set the lows for the year over the next 90 days. Personally I am becoming more bullish each day but remember Thursday saw a drop of more than 200 points after more than a 400 point gain on Tue/Wed. A market view can and does change daily with these types of market swings. Who would have thought at Thursday's close that Friday would see another 300-point gain?br>
FFor me the moves higher on the Nasdaq and Russell have been the positive clues to direction over the past three weeks. The Nasdaq rallied over resistance at 2350 on Wednesday and then fell back to use that level as support on Thursday. This is a textbook move and strongly suggests the techs are growing stronger day by day. The SOX has rallied off its 52-week lows but still faces resistance at 370. A breakout there could add some decent power to the Nasdaq rally. The strength in AAPL and RIMM is phenomenal and they alone appear to be pushing the Nasdaq higher but they had help from DECK, FSYS, WYNN, ISRG, ROCK, NILE and AMZN. There is definitely some buying interest in the tech sector and yet there are hundreds of billions in cash on the sidelines waiting for the "real" bottom. Their wait could pay off or it could be extremely costly. If the real bottom does not come then they end up chasing stocks higher with prices well above where they are today. This is that area where fortunes are made and lost for fund managers. If they jump in big and the markets roll over then they lose big. If they don't get in and the markets continue higher then they make smaller returns than their competitors and clients move their money and bonuses shrink. To compound this many funds have told their employees to take the month of August off because of the volatility and the expectations that we are going to see new lows. If they are wrong then there will be a lot of traders chasing stocks and techs and small caps is where they will be buying.

Nasdaq Chart - Daily

The Russell dipped back to 711 on Thursday after breaking above 720 on Wednesday. 710 is uptrend support and it used that level to blast off to a new high at 733 and a +3% gain for the day. The Russell is approaching its next serious resistance at 745-750 and a point where we could see further consolidation. A move over that level is a confirmed bull signal with next resistance at 800. I believe it is too soon to be talking about numbers over 750 until the bulls prove Friday's rally has legs. The Russell did break back over the 200-day average on Friday and that is a fund buy signal. br>
RRussell-2000 Chart - Daily

S&P-500 Chart - Daily

The S&P is lagging because the financials were holding back on Friday. There is still fear of future write-downs and potential bank failures. I checked the news sources this weekend and did not see any new failures but that does not mean there are not some in the pipeline. The S&P did close over the 1290 level but only by +5 points. That level was trouble in July. Current support is 1260. br>
For next week I would continue to buy the dips above Russell 710 but become more selective about what you buy. If the market does roll over I would be short or flat under Russell 697. As I said earlier the economic reports for the week are just filler and the earnings cycle is over except for a few stragglers. This is the time of the year where we should normally be very cautious about being long. I am hoping the early summer plunge moved that normal August/September drop forward by a couple months and that will bring the normal October rally into August. Still, hope about the markets will only get you out of bed earlier and it won't pay the bills. We need to trade what the market gives us and not what I hope will happen.

Jim Brown

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