The events in Libya and worries about contagion to Saudi Arabia and Kuwait gave the markets the excuse they needed for a well-deserved bout of profit taking. What happens overnight will be the key to market direction.

Market Statistics

It was all about Libya and oil today. The positive economics had very little impact. The opening drop blew through initial stops set by most traders and set the tone for the rest of the day. The eager bulls bought the initial dip to support at 1325 to produce a +10 point bounce on the S&P. When that bounce lost traction the continuing news from the Middle East soured sentiment and the markets started back down.

Those who were scared to death on the opening gap but did not have any stops set had followed the bounce higher and once the 11:AM decline began they began racing for the exits. When that 1325 support level broke at noon it began triggering a new group of stop losses and the shorts started piling on. The last leg down began at 2:30 with the margin selling began. Those who were margined to the hilt had to bail or were forced to exit by the brokerage computers as they began their closing sweep on margin accounts.

The markets posted the biggest one-day decline since August. Fortunately all the hysteria should now be priced into equities. The initial weak holders have been flushed and clearer heads will prevail on Wednesday. No real damage was done to the market and even with the decline the S&P only gave back the gains from the last week. The trend is still intact until we close under 1280.

We were due for a 2-3 day bout of profit taking and the crisis in Libya simply provided a convenient excuse. Of course the bears were out in force projecting the end of the world as we know it but without similar demonstrations in Saudi Arabia and Kuwait I seriously doubt we will be in for more than a minor decline all things considered.

Supporting the markets once the headlines move off of Libya were some good economics today. The Consumer Confidence survey for February spiked an incredible +10 points to 70.4 from 60.6. That is the highest level since February 2008. The expectations component rose to 95.1 from 87.3 while the present conditions rose only slightly to 33.4 from 31.1. An indication of the improvement in individual sentiment improvement was the spike in those planning on buying a car to 13.2% from 10.9%. However, those thinking about a new home declined from 5.2% to 4.4%. Those expecting an increase in income rose to 17.3% from 15.3%. In our current jobs market that is a huge spike in employee confidence.

Consumer Confidence Chart

The Richmond Fed Manufacturing Survey rebounded from last month's drop to 18 with a headline number at 25. That +7 point gain was huge and put the index at the highest level since May. Backorders rose to 12.0 from 5.0. New orders exploded higher to 27.0 from 17.0 for the fifth consecutive month of gains. The employment component rose by +2 points to 16 and the highest level since reporting began back in 1993. This is very bullish at least for the Richmond manufacturing area.

Richmond Survey Chart

The negative report for the day was a -2.4% drop in the Case Shiller Home Price Index. This is the third consecutive month home prices have declines. This decline is a year over year number and is for the December period. As a lagging number this report is mostly ignored.

The two important reports later this week are the Kansas Fed Survey and GDP.

Economic Calendar

After the bell today Hewlett Packard reported earnings of $1.36 per share compared to estimates for $1.29. Unfortunately that beat was not the only story. Revenue rose +4% to $32.30 billion but analysts were expecting $32.96 billion. It gets worse from here. Hewlett predicted earnings for the full year roughly inline with analyst estimates but projected revenue would be significantly below estimates. Hewlett predicted a median range of $130.75 billion compared to analyst estimates for $132.91 billion. Revenue in its services division fell -2% and PC sales revenue also declined.

Hewlett's CEO also squelched rumors that their tablet would be released earlier than expected to coincide with the iPad 2. He would not even give a date and that suggests they are having trouble in the manufacturing process. The advent of tablets, more than 110 models currently being offered by all vendors with dozens more in the pipeline is putting a crimp in PC sales. Without an active tablet in the Hewlett lineup they are suffering from a loss of market share. Once consumers buy a tablet from a competitor that takes them out of the market for a tablet from HPQ once it is released. HPQ shares dropped nearly -13% in after hours and gave back all the gains from 2011.

Hewlett Packard Chart

Apple shares took another hit with a -3.4% decline on rumors from an overseas broker named Yuanta Securities reported shipments of the iPad 2 would be delayed until June. There were also rumors the iPhone 5 would also be delayed. These rumors on top of the SEC and Justice Dept antitrust investigations pounded the stock. Steve Jobs is no longer the hot topic although he will be at the Wednesday shareholder meeting where a succession plan is sure to be discussed. All of these rumors will be hopefully be put to rest at the March 2nd media event in San Francisco. It is rumored the iPad 2 will be released at that meeting. If Steve Jobs actually shows up at the event it would go a long way towards healing Apple's stock price.

Apple Chart

Bank of America (BAC) declined -4% after the company said it was taking a $20 billion writedown charge to goodwill on Monday. The size of the charge scared investors even though it was non-cash and would not impact current financials. The charge was for the 2009 accounting period. The charge pertained to goodwill at its FIA Card Services division, which had previously taken a $10 billion charge for the same period. Investors believe a charge is a charge and should be treated as such. However, BAC explained it would not impact financial statements or profits but was a purely accounting adjustment.

The bank said it was reviewing prior accounts, segments and business operations and decided the charge they recorded in 2009 was not enough. It will not impact the current financials because it is on a division basis and the parent division was much better off than the lower level entity. Basically an upgrade to one canceled out the charge from another, which makes me wonder why even bring it up if it had no impact to the financial statements. I am sure they thought some sharp-eyed investor would see a $20 billion line item change at some point in the future and fault them for nondisclosure. After all $20 billion even on a statement with as many zeros as Bank America's would probably stand out. Since the common investor in BAC has no clue what all the accounting rules mean, they saw "$20 billion writedown" in the headlines and ran for the exits.

Chart of Bank of America

Home Depot (HD) reported earnings of 36-cents compared to estimates of 31-cents. Same store sales rose +4.8% in U.S. stores with international sales rising +3.6%. The average ticket size rose +2.6% to $51.31. HD also raised its forecast for 2011 for sales to increase +2.5% and raised earnings to $2.20 from $2.01 previously. The good HD news was erased by the market after a decent spike at the open.

Home Depot Chart

Amazon (AMZN) announced a video streaming service today to directly compete with NetFlix. Amazon said the service would be free to its Amazon Prime subscribers. A Prime subscriber pays $79 per year to get free 2-day shipping on any purchases for that year. The service will start with only 5,000 titles but Amazon plans to quickly ramp up the number of titles. The service will stream movies and TV shows commercial free to Prime subscribers. You can bet this will be offered on a stand-alone basis once they get the kinks out. NetFlix currently has about 20,000 titles according to analysts. Nielson said NetFlix streamed more than 200 million videos in January. That was a +37% from December. Google and Apple are constantly rumored to be considering an offer for NetFlix.

NetFlix Chart

Amazon Chart

The biggest event in the market today was not the decline in equities. The big news was the +7 dollar spike in crude oil. There were some qualifications. First the U.S. WTI contract was set to expire at Tuesday's close. There were thousands of traders short on Friday in expectations of a continued decline into expiration because of a lack of storage at the contract delivery point in Cushing Oklahoma. When Libya erupted the entire futures chain erupted but the short in the expiring contract were hurt the worst.

Also pushing prices higher was a claim of Force Majeure by Libya due to circumstances beyond the government's control. That means they don't have to honor any contracts and buyers expecting delivery suddenly have to buy oil on the spot market.

Another factor was the potential of contagion into Saudi Arabia and Kuwait. Libya is the 18th largest oil producer at 1.6 mbpd. Saudi Arabia is the largest OPEC producer at 8-10 mbpd depending on whom you believe. If demonstrations begin to breakout in Saudi Arabia it could be VERY bad for oil prices. Saudi has now been surrounded on all sides by demonstrations and government overthrow attempts in Bahrain, Yemen, Egypt, Libya, Algeria and Tunisia. So far there have been no credible demonstrations in Saudi.

The Saudi Oil Minister Ali al Naimi promised on Tuesday to produce more oil "if needed" to compensate for any loss of output from Libya. However, he emphasized that the market was very well supplied and there was no need to add any new production at this time. He said, "This is not 2008, supply and demand are equal."

The markets are very well supplied right now and there is no reason for Saudi to pump more oil. The fear that they won't be able to pump more oil if needed is the real problem. If Saudi begins to experience its own revolution we could see prices over $125 in a heartbeat.

Brent crude, the real price of oil in the global market, rallied to $108.70 late Monday and closed just over $106.

Chart of Brent Crude Prices

U.S. WTI Crude Chart

The airline sector was crushed by the spike in crude prices. For every $1 rise in crude prices it costs the U.S. airline sector between $415-$450 million per year. If the $8 spike in crude over the last two weeks were to stick that would be an additional $3.4 billion in expenses using an average of $425 million per dollar.

In the U.S. the impact to consumers is going to be expensive. Gasoline prices were already averaging $3.16 per gallon with prices much higher on the coasts. Economists believe for every 25-cent move over $3 per gallon it will cost the U.S. 600,000 jobs over the next two years. Everything costs more when fuel prices rise. This impacts profits, hiring and spending.

The U.S. imports just over 10 million barrels of crude and petroleum products per day. Our import prices are based on Brent, not WTI so they are already over $100 per barrel. This translates into more than $30 billion a month in money flowing out of the USA. That increases by $300 million a month for every $1 increase in crude prices. This is a form of fuel tax on businesses and consumers that the government can't cut.

I believe these prices will decline this time unless Saudi or Kuwait go the way of Libya and I am not expecting that to happen. When prices rise on higher demand in 2012 it won't be a problem that is so easily fixed and it will be permanent. The Great Energy Recession will be here in a few years and its impact will be lasting.

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I wrote last night we could expect S&P 1325 to be tested and I did expect that support to hold on the first dip. The opening low was 1325.10. When the +10 point rebound failed there was barely a blink when it passed that level on the downdraft the second time. The geopolitical conditions powering the decline were much more serious on Tuesday than what we had hear on Monday. Gadhafi's rambling war speech on Tuesday and the Force Majeure on oil deliveries was too much for the market to bear. Market volume exploded to 9.6 billion shares on stop losses and margin selling. Internals were 8:1 negative on volume and 6:1 negative on advance/declines. It was actually a pretty decent market flush although individual issues were not down significantly. It was broad rather than deep.

For Wednesday we will have the benefit of a pause to refresh. Everyone's emotions will have cooled and bargain hunters should be looking for targets of opportunity. "Should" is the key word. Personally I don't believe the sell off has legs. While I could easily see a 2-3 day event I would be shocked if we gave back many more points. There is risk to 1300 or even to 1280 but that would need some further events in the Middle East to really keep the party going for the bears.

The S&P declined to the 21-day average at 1313. A continued drop to test the 30-day at 1304 is very possible but I think that dip would be strongly bought. The key will be the continuing news cycle. We are not trading on fundamentals here. This is a news event and the instant is passes the markets should accelerate out of the dip. I suspect there will be plenty of investors "buying when there is blood in the streets" as Baron Rothschild recommended over a century ago. I know that is what I am going to be recommending tonight in Option Writer and OilSlick. Many traders have been waiting for a decent dip to remove their fear of buying a market top. Could the dip be larger? Absolutely but this is not the time to be timid. This is why stop losses were invented in order to protect ourselves against the market doing something we don't expect.

Remember, we had a similar dip on Jan 27th when Egypt was imploding. That dip took us back to 1280 and two days later all the losses had been erased. Egypt is more important to the world economy than Libya but the market got over it in a hurry.

S&P-500 Chart

S&P-500 Chart - Daily

The Dow actually looks better than the S&P thanks to Chevron, Exxon and Kraft, which closed positive for the day. The Dow declined to strong support at 12,200 and held. A break there could retest 12,000 but I would expect that to hold. The Dow will start off in the hole on Wednesday because of the -12% decline in Hewlett Packard after the close. That $5 drop should equate to roughly 40 Dow points.

Dow Chart

The Nasdaq was punished not only by news driven profit taking but by the huge declines in GOOG -20, PCLN -15, NFLX -14, AAPL -12, AMZN -6 and EXPD -6. The declines in Priceline and Expedia were related to the high oil prices and the impact on air travel. NetFlix and Amazon on the video streaming and Apple on the rumors. Combine them all together and the Nasdaq never had a chance with nearly a -3% decline.

The Nasdaq did pierce the 21-day and 30-day support but came to rest on the uptrend from August so the trend is still intact. The Nasdaq also pierced the 30-day average on the Egypt decline. I would have preferred it closed at support at 2760 but the actual close at 2756 is close enough for government work.

If this decline does continue I would expect stronger support at 2680 to prevail. Unfortunately that is about 80 points lower so let's hope we don't have to go there.

Nasdaq Chart

The Russell declined less on a percentage basis than the Nasdaq. While the difference was not large the signal from that percentage was huge. In any major market sell off the small caps in the Russell NORMALLY lead the decline by a large margin. Because they lagged the Nasdaq it means to me that fund managers were not onboard with the sell program. It suggests they will be snapping up bargains whenever possible. The Russell has strong support from 800-808 and closed at 812. Any further declines will face buying pressure and could be limited. However, if we see the selling intensify on the Russell it means the sentiment has changed and we should move to the sidelines.

Russell Chart

In summary I expect a rebound over the next 2-3 days because this is not a fundamental sell off. This is a news driven event and despite the news the changeover in Egypt was more important to the world than the madman fighting for his place in power in Libya. The difference is the amount of violence and the oil factor. I still believe we should buy the dip but we always have to be aware that what we believe is not necessarily what the market will do.

I will repeat what I said on Sunday.

We never know what new problem is going to pop up to cause us trouble. With markets at new highs they are very susceptible to event risk. Keep your stops tights and buy rebounds not dips. Buying the dip before the rebound begins could grow increasingly dangerous in the days ahead because we never know when that multi-day decline will arrive. Look for stabilization at the lows and evidence of an accelerating rebound before entering new plays.

Jim Brown

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