Monday's open was the high of the week and it was all down hill from there. Economic uncertainty was the motivating factor.

Market Statistics

The market dodged a bullet at the open with the Q1 GDP revision coming in at +2.7%. The consensus estimate was for a +3.0% gain. There were many who feared it could have fallen as low as +1.5%. The last revision was +3.0% and the first revision was +3.2%. This was the final revision to the Q1 numbers and analysts will now begin focusing on the Q2 numbers due out July 30th.

Expectations for Q2 and Q3 are slipping daily with Q2 estimates averaging +2% and Q3 possibly under 2%. This rate of growth is not sufficient to maintain employment gains. There is also the worry over the inflation rate. The CORE PCE inflation component in the Q1 GDP ended at +0.7% on an annualized basis and it is expected to fall again in Q2. The Fed would like to see it in the 2% range. There is a growing fear over a deflationary environment ahead.

GDP Chart

One problem heading in our direction is the end of federal stimulus. By January the $787 billion from stimulus bill will have been spent. State and local governments have run out of money to deficit spend. In the U.S. 46 states are facing a Greek style deficit problem. Money from Washington is drying up by year-end and those states will be facing a combined $125 billion budget shortfall despite already painful budget cuts. Those states will be forced to enact further budget cuts and raise taxes on citizens to fund the existing shortfalls. This is not conducive to economic growth. Employment is still weak and consumers are running on empty. Sales and income tax revenue has fallen for five consecutive quarters. That is the first time since 1962 that has happened. This will require major budget cutting by the states and more economic pain for consumers.

The federal government can't help because they have their own problems. U.S. debt will top $13.6 trillion in 2010 and rise to 102% of GDP by 2015. Publicly traded debt will rise to $14 trillion by 2015, up from $7.5 trillion in 2009. By 2015 the interest payments alone will be more than $1 trillion a year and 30% of U.S. government revenue. The government can't afford to renew the tax cuts at year-end and will be forced to let them expire. Putting those taxes back on consumers will only make matters worse for economic growth because it takes needed funds out of consumer's pockets.

This is a real problem for the economy and the markets. The nation is headed into a forced austerity program regardless of whether the government would like to spend more money. The markets are going to suffer as the year progresses because of the coming tax problem. Investors are going to take profits before year-end to avoid the increased taxes. That money will then go into bonds to wait out the economic stress. There are some tough economic times ahead.

Despite the coming economic stress consumer sentiment improved slightly in June. The headline number improved to 76.0 from the first June reading of 75.5. Obviously it was only a minor gain but it pushed the index to a two year high. The gains came in the current conditions index, which was probably influenced by the normal summer holiday euphoria. People normally feel better during the summer with vacations underway and the lack of daily school scheduling duties.

The next reading on sentiment for July will likely decline due to the massive press coverage of the drop in home sales. New home sales fell to a 40-year low after the tax credit expired. Up to 35% of those currently contracted to buy a home under the tax credit plan will be unable to close by the June 30th deadline according to the National Association of Realtors. To make matters worse the bill currently in progress that is trying to extend that deadline until September 30th failed again on Friday. If the non-farm payroll report next Friday comes in as negative as expected that will further depress sentiment.

Consumer Sentiment Chart

The Weekly Leading Index rose for the first time in seven weeks but only by a half a point to 122.9. However, the annualized growth rate declined even further to -6.9% from -5.8% the week before. The growth rate has declined 11 of the last 12 weeks. The minimal gain in the headline number is a statistical anomaly and will probably head lower again next week. The WLI is predicting serious problems in the economy in 2011. This is a forward-looking indicator for the period six months ahead. It is currently at the lowest level since July 2009.

WLI Growth Rate Chart

The American Trucking Associations' Truck Tonnage Index fell -2.8% in May on an unadjusted basis. Compared to May 2009 the index is still up +7.2% but the gains have been slowing over the last several months. Trucking volumes appear to have plateaued and could be starting to weaken. Trucks carry 68% of all goods in the U.S. economy.

ATA Truck Tonnage Chart

Globally the transportation picture is also slowing. The Baltic Dry Index, an index that tracks shipping costs of various dry cargoes all over the world has declined for the last four weeks and is in danger of a serious breakdown. The index hit a high of 4200 the week of May 24th and has declined to close at 2501 on Friday. That is a 1700-point drop or -40% in only four weeks. That is a serious indication that ship traffic is falling sharply. This is a major warning especially because the drop came in only four weeks. The only qualification would be this is a dollar denominated index and the dollar has fallen -4% over this same period. I am sure there is some impact from the dollar but not -40%.

BDI Chart

There is a definite smell of recession in the air or maybe it is deflation instead. It appears that on June 1st an email went out saying "recovery is over, prepare for the second dip." The bounce on the China export and Brazil GDP news was the sucker's rally and now everyone is bearish again. I want to know how to get on that email list because I did not get the email. Somewhere a straw fell and broke the back of the recovery. Obviously there were a lot of straws falling in May but the proverbial last straw must have finally fallen.

The financial regulation reform bill reached critical mass on Friday and is expected to pass next week. Bank stocks rallied late Friday in relief that the changes were over. Unfortunately many of the changes won't actually take form until the new regulatory body actually takes the document and turns it into rules.

The Volcker rule is in the bill but it was watered down slightly to allow banks some leeway in trading for their own benefit. They can speculate with up to 3% of their capital in private equity and hedge funds. Banks are also allowed to deal in derivatives in order to hedge their own risk but not to speculate on risk as a trade. This will keep companies like AIG from writing credit default swaps on anything without any capital reserve to back them up. The bill calls for derivatives to be traded on public exchanges like the CME.

Small banks are expected to see a profit hit of between 2-4% while larger banks could see a hit up to 10%. One of the biggest problems is the additional capital requirements. Some analysts believe capital requirements could rise to as much as $5 trillion. Any additional capital requirements would come out of available funds for lending. This means there will be less credit available to customers. Banks have been hoarding cash for the last year in expectations of both a second dip and the increased capital requirements. How it will actually impact their requirements won't be known for months. Smaller banks have five years to raise their capital to meet the new rules.

Banks will lose billions from restrictions on things like overdraft fees and service charges, which will be either eliminated or significantly reduced. Chase is reportedly going to lose $350 million a year in fees. You can bet they will show up in some other form. Customers will always end up paying any fees caused by regulatory changes. They will just be called something else.

Banks rallied because the process was over. There were fears the rules could have been a lot worse and many rumors were already priced in. This was a relief bounce but we still don't know how this will translate to actual rules.

Wal-Mart (WMT) is heading south at a high rate of speed. With the democrat's successful cram down of the bank reform and the negative results in the primaries, analysts believe Wal-Mart will be next on the target list. The democrats are going to be hell bent to pass everything they can before the November elections because the odds are very good they will lose their majority and new social reform programs will be DOA. Card-check is expected to be next in the hopper along with immigration reform and cap and tax.

The card-check program was introduced in Congress in 2005, 2007 and again in 2009. Basically if more than 50% of workers for a given store or enterprise fill out an authorization card requesting a union then the union becomes the official representative for the workers. It is basically a forced union on the employer. President Obama supports the Employee Free Choice Act and is reportedly talking it up again behind closed doors in an effort to boost the voting base for the democrats. Union members typically vote democratic. Wal-Mart is not a union store and being forced into a union business would raise prices for everyone and raise costs for Wal-Mart. Wal-Mart closed at a new 10-month low on Friday. I also heard the financial reform bill had a clause in it that would make it harder for Wal-Mart to start a bank. Unfortunately I could not find anything online about that clause. The final documents have not yet been released.

Wal-Mart Chart

BP fell to another new low today at $27 after the weather service said there was an 80% chance the storm south of Cuba would turn into a cyclone. The storm reached that level Friday night and is now named Alex. It is headed for the Yucatan peninsula this weekend and will enter the gulf early next week. As of late Saturday the storm is expected to move west of the well and hug the Texas coast.

BP is praying it falls apart over the Yucatan and dissipates into an unorganized disturbance that will not force them to leave the well site. There are roughly 60 ships clustered around the leaking well and should the storm develop into a hurricane it would be very bad for the recovery effort. The ships would have to pull up the pipe and hoses and run for cover. They need four days to break camp and six days to rebuild it once the storm passes. That means the well could be running full blast dumping up to 50,000 bpd of oil into the gulf for 14 days due to storm disruption. This would increase the environmental damage in the gulf by a factor of 2-3 times.

Secondly if the storm turns into a hurricane it would increase the pollution significantly on the shores of the gulf. The storm surge would push oil much further inland as well as up marshes, streams and rivers. It would be an even bigger disaster than it already is.

British Prime Minister David Cameron met with President Obama on Saturday at the G20 and BP was on the list of topics to be discussed. Cameron is catching a lot of heat at home over President Obama's constant persecution of the company. Cameron said he wants some finality to the damages and the cost to BP. He does not want BP to be destroyed since 40% of the shareholders are British. I doubt he will get a cap on costs since the well is still leaking. I doubt he will get a commitment from Obama to quit slamming BP in speeches since Obama believes that is a way to regain credibility. News out late Saturday claims the pair both agreed that further harassment of BP or putting them out of business would not benefit anyone. It will be interesting to see how long that commitment lasts.

NOAA Weather Chart

Storm Track

Chart of BP

The risk of a storm was credited with pushing crude oil prices +3% higher to close just under $79. I believe that reason was bogus. This rebound off support at $75 was to be expected as the quarter comes to a close. In fact commodities in general saw strong gains as funds tried to find something to park money in for the end of the quarter. Commodities are always favorite places to hide until the quarter end passes.

There was no fundamental reason for oil prices to move higher. There is plenty of oil in inventory and about six million barrels per day in excess production capacity. The declining economics in Europe and the U.S. are depressing demand. The IEA said last week that demand factors would continue to slow through 2015 although there would still be overall demand growth. In other words demand growth would decline to only 1% per year instead of averaging 1.5% as previously expected.

Crude Oil Chart

Apple claimed it sold over one million iPhone 4 phones on the first day of sales. This came despite the claims the new antenna positioning is causing a reception problem. The solution to the problem according to Apple is to hold the phone differently or get a case for it. Seems the human body and moisture in your palms tends to degrade the antenna reception on the new phone. Steve Jobs made a big deal out of the new design during the presentation calling it "really cool engineering" to put the antenna in the outside metal band on the phone. I guess it is really cool if you like losing two bars of power when talking.

While there are numerous videos on the web showing the problem there are also many claims by users that they cannot recreate the reception drop on their phone. AllThingsD.com ran a comparison and pointed out that nearly all cell phones including the various Android versions and even the BlackBerry suffer reception signal strength depending on how you hold the phone. I doubt Apple will issue a recall since the answer is simply to put a case around it and 90% of users do that anyway. Apple stock has been losing ground since the problem was first announced but so has the market so it is tough to say which is the cause.

Apple Chart

The economic calendar for next week is full of potential problem reports. There are three ISM reports and a double dose of news from Chicago. The ISM report on Thursday will be the key one that shows manufacturing trends nationwide.

The big report is of course the non-farm payrolls on Friday. The Moody's estimate is for a loss of -155,000 jobs. The various jobs estimates are going to be quoted all over the place next week with ranges from -100K to -500K. The big drop everyone is expecting is the decline in census workers. The real key will be the core rate after subtracting the census workers. Morgan Stanley is looking for a gain of +150,000 jobs. That is astounding after a net gain of only 41,000 in May.

They are basing this on the CEO hiring survey. CEO's reportedly have the strongest hiring confidence in the last three years. Whether that is translating into new jobs remains to be seen. Weekly jobless claims remain stubbornly over 450,000 with a four-week high at 472,000 in the prior week. This is not evidence of CEO hiring.

There is also the problem of the oil spill. The governor of Louisiana claims 150,000 people are out of work because of the spill and the moratorium. Those job losses could have been reported in the May payrolls because the spill has just crossed into its third month.

I believe the payroll report plus the national ISM will be a weight on the market all week.

Economic Calendar

Friday was the annual rebalancing of the Russell indexes and that always creates unusual volume. The rebalance removes stocks that have fallen in market value and replaces them with stocks that have risen in value. The Russell 3000 is the top 3000 stocks in the U.S. with the Russell 1,000 the top 1,000 of those stocks and the Russell 2,000 the bottom 2,000 of those stocks. There is $3.9 trillion in investments benchmarked to the Russell indexes.

The value of the shares being added is greater than the shares being removed so the rebalance requires fund managers to sell some of the 2,700 stocks not being removed in order to buy the appropriate amounts of the new stocks being added. According to fund analysts, fund managers needed to raise $14 billion from the sale of other stocks in order to make the switch. Volume on Friday was 11.6 billion shares compared to an average of only 8 billion shares the rest of the week. O Friday there were roughly $10 billion in market on close orders for Russell 1,000 stocks.

Berkshire became eligible to join the Russell 1000 after a 50:1 stock split on the class B shares. It joined the S&P-500 on Feb 12th and is the 13th largest weighted stock on the S&P. Needless to say it will be very highly weighted on the Russell 1000 and there were 109 million shares traded late Friday. BRK.B averages less than 5 million shares per day.

I don't know what to attribute to the intraday rebound on the indexes other than we have had an intraday rebound for the last three days. The bulls are trying to produce a rally but the selling at the close is killing them. As long as the close is sold the downtrend is going to continue.

The S&P collapsed this week with a 3.6% loss to 1078 after trading as high as 1131 on Monday. The S&P is right in the middle of the range where it spent most of May and early June. Despite the loss this week the trend for the last six weeks is still range bound. A continued drop below 1070 next week will be the signal for the next leg down. Baring unforeseen events I would expect to see 1050 again. However, next week is a holiday week. Volume will be very light and it is typically bullish. Countering that historically bullish sentiment is a raft of economic reports punctuated with the nonfarm payrolls on Friday. That should keep a lid on any rally and possibly keep the pressure on the current range. Support is 1050, resistance 1110.

S&P-500 Chart

The Dow chart is a carbon copy of the S&P with the close at 10143 right in the middle of the recent range. Psychological support should be 10,000 but 9800 is the real target on a continued slide. If it were not for the rallies in JPM and AXP the Dow could have been much more negative. Many of the Dow big caps were down a buck or more. That included KO, WMT, PG, IBM, XOM and JNJ.

Dow Chart

The Nasdaq overcame a monster decline in RIMM and a $2.30 decline in Apple to remain in positive territory. Research in Motion was crushed for an 11% drop after reporting earnings that were less than exciting. With Apple's iPhone 4 and multiple versions of phones with the Android operating system taking market share from the longtime favorite the future looks bleak. Credit Suisse said volume on the other smart phones was going to quickly erode prices and competition for the BlackBerry was going to increase. The BlackBerry remains the phone of choice for the business community but the iPhone and the Android are catching up. RIMM fell to a level not seen since March 2009 at $52 and took a sizeable chunk out of the Nasdaq.

Winners on the Nasdaq included the CME on financial reform along with PCLN and ISRG. The winners outpaced the losers and the Nasdaq managed to rebound off support near 2200 and close slightly positive. Support remains the 200-week average at 2220 and the June lows at 2140. Resistance is well above at 2320.

Nasdaq Chart

The Russell found support at 635 for the last three days but we really can't use the Russell as an indicator this week because of the rebalance. The 620 level is still the critical support point.

Russell Chart

The Dow transports appear to have found support at 4200 and that could be an early indicator of some returning market sentiment. If investors are anticipating an economic rebound this sentiment should be seen in the transports first. Personally I believe this is just a pause point ahead of another decline because the economic factors are weakening. A break under 4200 targets a retest of 4000.

Dow Transports Chart

I remain bearish until proven wrong. The S&P failed at 1100 and is in correction territory again. The 1050 level is beckoning and there are numerous economic reports this week that could contain bad news. Even if we did get a couple days of gains heading into quarter end I would be skeptical until we see what happens as Q3 starts. There are normally gains around quarter changes but the key here is whether or not they stick.

Earnings will start after the July 4th holiday and guidance is not expected to be strong. There are many reasons to be bearish over the next three months and very few to be bullish. The next couple months would probably be put to better use on the golf course or the lake than in the markets.

Jim Brown