The markets faced major earthquakes and tsunamis, unrest in the Middle East, falling consumer sentiment, plunging oil prices and the impending FOMC meeting but the bulls climbed the wall of worry to push the indexes back into the green.

Market Statistics

The big news for Friday was of course the major earthquake in Japan. It was the strongest earthquake on record for Japan and the seventh largest ever recorded in the world. Damage was extensive even though it was centered well offshore and 15 miles under the surface. The quake created a 23-foot high tsunami that washed through coastal areas and destroyed everything in its path. Tokyo was 186 miles from the quake center but was still rocked by the quake with damage to glass and buildings. Eleven nuclear power plants had to shutdown due to damage. More than four million buildings lost power. Three refineries were on fire and a total of five were offline. There are no accurate estimates for loss of life because so much of the devastated areas were simply washed away.

One reactor at the Fukushima Daiichi facility appears to be in the process of melting down. Radiation levels in the control room surged to 1,000 times above normal and levels near the main gate were 70 times normal. The government widened the evacuation zone from 3km to 20km after the plant exploded on Saturday destroying the containment building. A different facility, the Fukushima Daini plant, also reported temperatures were rising inside the reactors and it had lost control over pressure in the reactors. A 3km evacuation zone was imposed around that plant as well. All the reactors shutdown automatically when the quake occurred but diesel powered cooling systems also failed. Even when offline the nuclear fuel needs to be kept cool. This quake could put another hold on new reactor approvals around the world until a solution is found to prevent future problems. Earthquakes are not going away.

The disaster in Japan actually improved our markets overnight. The futures were down hard after the Thursday decline and routine news out of Asia and Europe was continuing to depress sentiment. The quake news seemed to distract investors from their prior worries and the sentiment changed back to a buy the dip plan.

The Saudi Day of Rage evaporated and nobody showed up at either rally point in Riyadh except for riot-clad policemen. Multiple police cars blocking intersections for blocks in any direction and hundreds of riot police evidently convinced demonstrators to stay indoors. In the city of Hofuf, near the Ghawar oil field several hundred protestors congregated briefly to voice their grievances but the demonstration evaporated quickly when riot police and armored personnel carriers began to appear. Apparently the harsh methods used on Thursday to breakup a prior demonstration was more than these people wanted to deal with on Friday.

Prince Alwaleed bin Talal al Saud, nephew to the king and chairman of Kingdom Holding, said it should be renamed from Day of Rage to Day of Allegiance since no protestors in Riyadh was seen to be a vote of confidence for the king's recent $35 billion stimulus program. I suspect Prince Alwaleed is a little biased and this was his effort to be a cheerleader for the king. The prince is inline for the throne but way down the list of potential candidates.

The lack of a major clash in Saudi Arabia caused investors to breathe a sigh of relief and oil prices plunged. The news of the largest rally in a month in Yemen with demonstrators fired on by police and violence between demonstrators and police in Bahrain was ignored. Neither country has any material oil production.

Oil declined for multiple reasons. The first was the lack of a material protest in Saudi Arabia and the second was the expected drop in demand by Japan. With five refineries offline, some for an extended period to make repairs, the demand for oil for Japan is going to drop sharply. Japan is the third largest importer of crude in the world at 4.4 million barrels per day. The anticipated drop in refining and the decrease in driving due to the thousands of cars washed inland and piled up like cordwood and the severe damage to hundreds of roads and bridges helped push oil prices lower. Video of the wall of water pushing hundreds of cars across the countryside and the pictures of piles of cars in the hundreds when the water receded was simply amazing. It could be a long time before transportation returns to normal in Japan.

The decline in demand from Japan is estimated to be around 2.0 mbpd. This would easily offset the loss from Libya. This pushed WTI prices as low as $99 intraday and Brent $112. They both closed off their lows but I think it was a short covering bounce. Late in the day analysts were predicting a sharp increase in refining in other areas and the need for Japan to import large quantities of gasoline and diesel. With eleven nuclear plants offline, some possibly for months, there will be a very high demand for diesel to power diesel generators for buildings and emergency facilities. Plus the heavy equipment and trucks used to clear away the debris will be consuming large quantities of diesel. This will take a few weeks to see how demand actually changes so I would not expect crude to really take a dive but I do think the top in prices is behind us. Energy stocks did rebound strongly on Friday because an oil drop to $100 is still well above profitable levels for oil companies. WTI between $95 and $99 is the sweet spot for crude. Not high enough to drive gasoline to levels where driving slows materially but high enough for oil companies to profit from increased cash flow and direct that money back into capital spending.

WTI Crude Chart

Brent Crude Chart

On the economic front Consumer Sentiment for March plunged to 68.2 from the 77.5 reading in February. That was the eighth largest drop since records began in 1978. According to analysts the drop was due to the turmoil in the Middle East and the soaring gasoline prices. The sharp drop in the stock market over the last two weeks was also a factor. The biggest change came in the expectations component, which fell -13.3 points to 58.3 from 71.6. The parade of analysts predicting higher oil prices for the rest of the year created a serious cloud of frustration. Most consumers live from paycheck to paycheck and often run out of money before they get paid. Faced with gasoline prices headed for $3.75 per gallon from $2.75 just a couple months ago that equates to an average of an extra $20 per fill up. For a two-car family that equates to more than a $100 pay cut. The extra money they got from the social security tax cut has now been completely erased by the gas hike.

Consumer Sentiment Chart

Retail Sales accelerated in February to a +1.0% gain and the strongest growth since October. This was before the recent increases in the price of gasoline but there was enough of an increase to push gas sales up +1.4%. Sales year over year are now up +8.9%. Improving weather was a contributing factor. Bad weather in January pushed shopping into February so this number is slightly misleading. The biggest gains came from autos and auto parts at +2.3%. The weakest area was furniture and home furnishings with a -0.8% decline.

Business inventories rose +0.9% in January and inline with expectations. It was another good month after the small dip in November. The trend to add to inventories is growing and this is bullish for the manufacturing sector. This is a lagging report and was ignored.

The Job Openings, Labor Turnover Survey showed job openings declined from 2.921 million in December to 2.76 million in January. The majority of declines were in the construction and hospitality sectors and that was probably due to the harsh weather conditions in January. This is a lagging report and was overshadowed by the major events on Friday.

The calendar for next week has some big events. The biggest is the FOMC meeting on Tuesday and the potential for the Fed to change their statement. As you know I believe the market weakness over the last week was due to hedge funds taking profits ahead of that expected statement change.

We also have the PPI and CPI on Tue/Wed and while they are not expected to show any big jumps in inflation we are always just one report away from a catastrophe. A sharp spike in inflation could turn the Fed bearish in a heartbeat and that would be seriously negative for the market.

The Philly Fed survey on Thursday is a proxy for the next ISM report and estimates are for a decline to 32.4 from 35.9. Some believe the manufacturing sector may be slowing slightly although to date there has been no indications in the various regional reports. The Philly Fed would be market negative if the decline appears.

Economic Calendar

In stock news Friday was very quiet. The quake was about the only news moving the market. The severe damage means Japan is going to have to spend hundreds of billions on reconstruction and that was powering stocks like Caterpillar (CAT) and AK Steel (AKS) for obvious reasons.

Apple (AAPL) shares rallied $5 ahead of the start of iPad 2 sales this weekend. An analyst at Gleacher & Co. said Apple could sell 600,000 units this weekend alone. That is twice the volume of the original iPad when it went on sale. The iPad 2 is vastly superior to the iPad 1 and sells for the same price. Everyone who waited for the new and improved version without the initial device bugs should be very happy they waited. The first version sold over one million units in the first 28 days. Apple is expected to sell 20 million of the iPad 2 this year. Sales of just the iPad 2 in 2011 will generate more revenue for Apple than Dell Computer will generate from all sources in 2011. The iPad 2 goes on sale in 26 other markets on March 25th.

Apple Chart

Aflac (AFL) is watching the damage in Japan carefully. Aflac sells health and life insurance to 25% of the population of Japan and the Aflac CEO said they could have claims from 3-4 million people. They don't expect a lot of deaths but they do expect a lot of injuries. The CEO said Aflac was fully prepared to handle all the claims. Property damage claims were expected to be a lot larger because of the dramatic damage from the tsunami. A Credit Suisse report said insured damage could be in the range of $10 billion to $50 billion. The major reinsurers like Hannover Re declined about 5%. After gapping lower at the open Aflac rebounded on the CEO comments to nearly flat.

Aflac Chart

European leaders agreed on Saturday to strengthen the euro zone bailout fund, make its loans cheaper and lower the interest rate on loans made to Greece. They are going to extend the term on the loans to Greece to 7.5 years from the current three years and cut the interest rate by 100 basis points. The European Financial Stability Facility (EFSF) will increase in size from €250 billion to €440 billion. Any new loans to any EU country will be based on IMF rates but incur a 300 basis point penalty fee and a 50 basis point service charge. Ireland could also benefit from the lower rates but only if they agree to change their corporate tax rate. Ireland has a 12.5% corporate tax rate. The EU leaders could agree to a deal on Ireland when they meet on March 25th. The EFSF is scheduled to be replaced by the European Stability Mechanism (ESM) in 2013 and the size of the fund raised to €500 billion.

I believe this EU news will be bullish for our markets on Monday. The resurgence of the EU debt crisis with the Spain downgrade on Thursday helped to tank the markets and the resolution to upgrade the EFSF is a positive step to solve those debt problems.

The S&P dipped below support at 1295 by -3 points on the opening dip but quickly recovered. I wish I could say it was followed by a strong rebound that pushed the index significantly higher but unfortunately that did not happen. If you get out your microscope and examine the intraday chart carefully you will see the initial bounce was able to move past 1300 by a miniscule +3 points and then it used 1300 as support for the rest of the day. I do view that as slightly bullish. At 2:PM another move higher began to 1308, probably short covering, but it was sabotaged at the close by fear of darkness selling. With the weekend event risk still pretty high I am surprised we did not close flat to down.

On the bright side there were no sell programs dumping millions of shares. I actually think Friday was bullish despite the lack of a material gain. I am not complaining about +9 points but after the -24 point drop on Thursday a +9 point gain is fairly anemic.

The key idea here is that support at 1295 held and we closed above 1300. The EU agreement to raise the loan limits on their bailout fund and the lack of a major event in Saudi Arabia over the weekend could be market positive on Monday.

On the downside we had a lower low on the S&P and the Russell barely made it into positive territory. The FOMC meeting on Tuesday is a major stepping-stone in the wall of worry. I would be perfectly happy for the S&P to just remain over 1300 for two more days to get us past that hurdle. A continued rebound above 1300 would be a gift.

S&P-500 Chart

The Dow was looking good late in the afternoon with a triple digit gain. However, that fear of darkness settled in and the morning buyers retreated with what little profits they had gained. The Dow gave back nearly half of its intraday gains.

Like the S&P the Dow dipped below support at 12,000 on the opening drop but when the bears could not capitalize on the opening decline the buyers came back. The Dow was helped by gains in CAT and MMM on expectations for sales to Japan and by gains in CVX and XOM on rebounding oil prices in the afternoon.

When the Dow reached the afternoon highs from Thursday at 12,075 the sellers returned but it was 3:30 PM so I attribute that to fear of weekend event risk more than a resistance failure.

The Dow closed just a stones throw from psychological support at 12,000 but we saw new support develop at 11,950 so there are two levels to be broken before a true breakdown can occur. Real resistance is still 12,250 but I doubt we will have to worry about that on Monday.

Dow Chart

Despite the +14 point gain there was no joy on the Nasdaq. About the only thing to say positive about it was the decent jump back over 2700. The techs are still overall weak and Apple, NFLX and BIDU were the major reasons for the Nasdaq rebound with each gaining over $4. Apple should continue to move higher as weekend sales numbers for the iPad 2 are released. There were pictures on TV of lines wrapping around the block at several Apple stores. Some were 500 people long and each person was limited to "only" two iPads. Who knows how long that buzz will last before we get a sell the news event on Apple? Whatever happens to Apple stock happens to the Nasdaq since Apple is 18% of the NDX.

The Nasdaq chart is far from bullish and bordering on the edge of a serious breakdown. This is one of those make it or break it weeks and something positive needs to happen on Monday to pull us back from the brink. We could survive a dip to 2675 and maintain the overall bullish trend but that would be an extreme example of living dangerously.

I said on Thursday the Nasdaq was my indicator for Friday. The rebound was lacking conviction and it is still my indicator for market direction on Monday. This is the index that should lead us next week.

Nasdaq Chart

Trading in the small caps on the Russell should have been halted on Friday for lack of interest. After dropping -21 points on Thursday to say the +3 point rebound was lacking conviction would be an understatement. I was happy to see the support at 795 hold but you would have thought the rebound would have been stronger.

Fund managers are clearly hesitant to hold small caps over the FOMC meeting on Tuesday. Add in the return of the EU debt crisis on Thursday and I am not surprised we tested that 795 support. Now that the EU credit facility has been expanded we could see that small cap sentiment change next week. I doubt it will be before the FOMC announcement. A change in bias for the Fed would initially be a disaster for small caps but positive long term.

For Mon/Tue the 795 level needs to hold to maintain at least a shred of positive sentiment for later in the week. Resistance is so far above at 830 that it is immaterial.

Russell Chart

The indexes pulled back to critical support ahead of FOMC. The expectations for a statement change are rampant and if the Fed is NOT going to change the statement negatively I believe they need to make a positive change to get this cloud off the market. Bill Gross has said repeatedly the Fed needs to give better direction than the "extended period" language. Gross sold all the U.S. debt in the Pimco Total Return Fund because he is afraid of the market reaction when the Fed does announce the end to the QE2 program. That Pimco news last week was confirmation to the market the Fed was about to make a change in the statement to either confirm termination in June, say they are going to back off on the total amount or simply end it earlier than previously scheduled.

New York Fed President William Dudley said on Friday the Fed is "very far away" from achieving its mandate of high employment and price stability and "faster progress toward these objectives would be very welcome." This was seen as a signal the Fed was not going to change its policy any time soon. Now we need the FOMC to confirm that on Tuesday.

I believe we are at a pivotal point in the market. The pullback to critical support ahead of the Fed meeting has setup either the beginning of a strong rebound into Q1 earnings or a complete breakdown that could last through the summer. I vote for the rebound scenario but my vote does not count. Bernanke's vote does count and I am betting he does not want to tank the market next week. He has spent the last six months pumping up the stock market with record buying of government treasuries and all would be for nothing if he allows the market to crash before the recovery becomes self-sustaining.

He knows the rise in gasoline prices is going to be a drag on the slowly growing economy. He needs to keep the pedal to the metal to keep the economy moving forward until the Libyan crisis ends and oil prices drop back into a safe zone. This oil spike may have changed the Fed's plans and could even cause them to extend QE2. I know that sounds unbelievable today but it would have less political risk than adding a QE3. Extending it another six months at a lesser rate would take all the pressure off today and hedge funds would be racing back into the market.

I am looking forward to Tuesday night's market commentary. Hopefully the fog will have cleared and we will have a concrete idea on market direction.

Jim Brown

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