The equity markets may have seen some minor profit taking last week but anyone with commodity positions probably ended up at a bar on Friday drinking their troubles away.

Market Statistics

Commodities other than oil were relatively tame on Friday but the better than expected jobs report sent oil prices on another wild ride. Crude traded as low as $94.63 and as high as $102.38 before crashing back at the close to $97.30. More jobs means more people driving to work every day but it was not long before the underlying bad news came back to haunt the energy sector.

The headline number on the Non-Farm Payrolls showed a gain of +244,000 jobs compared to a gain of +221,000 in March. The private sector created 268,000 jobs but that was offset by a -24,000 decline in government positions. February and March numbers were upgraded by another 55,000 jobs.

The service sector added +57,000 jobs and the most since 2000. Leisure and hospitality also grew significantly by +46,000 and professional/business services gained +51,000. Manufacturing grew by +29,000.

Non-Farm Payrolls

The bad news came from the normally bullish household survey. Household employment fell by -190,000 and full-time employment fell by -291,000. This spiked the unemployment rate from 8.8% to 9.0%. The actual number of people out of work remained the same at 13.7 million (officially on the unemployment rolls) and more than 20 million if you count those who have given up looking for work and are off the unemployment rolls or took a part time job to pay the bills. There are more than 8.6 million people in that classification.

If you only look at the Non-Farm numbers at +244,000 it appears the economy had defied the payroll declines in the recent regional reports and actually added jobs. However, if you combine the numbers from the Non-Farm and Household surveys it was a negative month. You have to love statistics like this because reporters can produce any story they like just by using a subset of the statistics.

We all heard in April about McDonalds hiring 62,000 workers. Those were not included in this report because the hiring came after the survey was completed.

To put the April report even more into perspective you have to realize that the labor force expanded by 235,000. That means if you just look at the +244,000 non-farm additions and the increase in workforce additions of +235,000 unemployment only decreased by -9,000 jobs. Obviously it is positive to create more jobs than there were people entering the workforce but at that rate it would take the rest of the century to eliminate the 20+ million unemployed. The majority would die from old age before they got a job.

I am really worried about the direction of the economy based on the Household Survey and the recent decline in employment in the regional economic activity reports. I think the non-farm numbers are a smoke screen that could disappear in the May report. Remember we saw sharp declines in economic activity in almost all the regional reports. Something does not compute and I hope I am wrong on the direction. Nothing would please me more to see a rebound in the household employment next month and a continuation of non-farm payroll gains but I will not be holding my breath.

Next week has a relatively benign economic calendar with the most watched reports closer to the end of the week. The two price indexes will be watched for inflation pressures but after the commodity implosion this week any gains in those reports will be ignored.

The earnings cycle is drawing to a close and there are only a few names reporting that most people will recognize. Cisco is the big dog on Wednesday but they have already lowered expectations so I doubt they will move the market.

Economic Calendar

The big news last week was of course the commodity implosion caused by the silver crash. I wrote on Thursday night that I believed the corresponding crash in oil, copper, etc, was caused by silver and not because of a specific weakness in fundamentals for those other commodities.

The silver crash was caused by the CME more than anything else. Yes, silver was over extended but markets and commodities get overextended all the time without a 27% drop in four days.

The CME raised the margin requirement for silver five times in two weeks or roughly every 48 hours. Every margin hike created thousands of margin calls that had to be covered immediately either by selling silver or some other commodity position. Add in the crash in the price pushing accounts into negative margin and it turned into an implosion. Any other futures asset in trader's accounts was sold in a panic attempt to avoid forced liquidation by the brokers. Traders were in panic mode to cover those margin calls and they could not do it fast enough with equities and they did not want to disrupt long term positions to cover a short-term problem. Selling futures was the only answer.

To complicate this problem the dollar exploded and the Euro imploded. Since QE2 was announced we have seen nearly every hedge fund and speculative trader with any clout shorting the dollar to buy commodities and equities. After all if the government is printing money that is the logical trade. The dollar fell to nearly three year lows with traders leveraging up on every downtick and every Fed speech saying QE2 would continue.

Then the ECB failed to raise interest rates on Thursday and that sent the Euro into freefall and the dollar exploded. Add in the rumor that Greece would leave the Eurozone and now everyone short the dollar and long commodities had another reason to panic sell. Sometimes when it rains it pours.

Currency traders are normally leveraged between 10 and 100 times more than commodity traders. When things go bad for them they go really bad and this was an example of really-really bad. That accelerated the margin call problem significantly as they tried to cover the growing back hole in their accounts.

Euro ETF Chart

Dollar Chart

I repeated the explanation from my Thursday night commentary to explain why the other commodities are not broken. Specifically I am going to talk about oil since it was the second biggest decliner with a 13% drop. Oil was over extended. In the Oil Slick newsletter we had been expecting a decline for the last 3-4 weeks and had exited nearly all our positions in anticipation of the drop.

Being overextended is different than being parabolic as we were seeing in silver. The Dow was also over extended but that did not mean a new bear market was going to appear in just a week. It just means that prices needed to cool before moving higher.

In the oil sector the second quarter is typically the low oil prices for the year. That trend was broken when the unrest in the Middle East starting with Egypt and Tunisia and ending with the loss of production from Libya. That pushed the prices to two-year highs rather than let them sink over the normal spring refinery maintenance period. The cycle was out of alignment and needed to see the pressures equalized.

I seriously doubt we would have seen anything close to the correction we got in oil without the margin panic from the silver crash. Oil does not drop $10-$12 in one day. That is not a normal move in any cycle. We basically saw a mini flash crash in commodities where the interrelationships among certain types of trades and traders removed the fundamentals from consideration.

That commodity flash crash may be behind us but it may not be over. Just like with the Japan earthquake there may be aftershocks for days or weeks to come in the commodity sector. Just like the May 6th 2010 flash crash in the equity markets the current flash crash has severely shaken the confidence of commodity traders. The crash probably severely crippled thousands of brokerage accounts as well. Billions of dollars were lost in the decline. That will have repercussions for months to come for many accounts. Some may be out of business. It was a once a decade type of event. Maybe even longer.

I explained the scenario to show that oil is not broken despite the decline from $114 to $97. Nothing changed in the fundamentals. Supply is still shrinking and demand is still growing. It may be growing slower than it was 90 days ago because of the high prices but it is still growing.

In reality the drop in prices will be good for demand. Gasoline futures dropped 40-cents to $3 a gallon before rebounding to close the week at $3.09. The high for the week was $3.42 on Monday. This will have a dramatic affect on the price at the pump. Where the U.S. average price was $3.985 last week it could decline 25-cents over the next couple weeks. Also, the refinery maintenance cycle is over and they will be ramping up production of gasoline for the summer driving season that begins in three weeks. That will also depress prices with more gas on the market. Both of these events are good for demand because prices could drop back to $3.50-$3.60 per gallon and after seeing that $4 handle last week a $3.50 price will look positively cheap.

The major brokers were tripping all over each other to recommend buying the dip in oil. Goldman, who had been recommending selling oil just three weeks ago said oil should make new highs after the correction is over. They said prices will surpass recent highs by 2012 because of shrinking capacity and increasing demand. "It is important to emphasize that even as oil prices are pulling back from their recent highs, we expect them to return to or surpass the recent highs by next year." Also, "We continue to believe that the oil supply-demand fundamentals will tighten further over the course of this year, and likely reach critically tight levels by early next year should Libyan oil supplies remain off the market. The sell-off yesterday (May 5th) has likely removed a large portion of the risk premium that we believe has been embedded in oil prices, which could suggest further downside may be limited from here." They did not rule out a further short-term decline but suggested this was a buying opportunity.

Barclays said the current levels represented a good buying opportunity."While further downside weakness cannot be ruled out, the general trend should be higher rather than lower. Fundamentals have not changed. We have diminishing spare capacity, global demand increasing and supply side issues so the factors pushing prices higher are still there."

JP Morgan actually raised its estimates on Friday saying Brent crude will rise to $130 in the third quarter and that would restrain demand in the fall. JPM said, "While financial bushfires or perhaps a rapid resolution to the Libyan civil war could radically alter market dynamics, the balance of both risks and fundamentals still points to a supply-constrained world."

JPM said its current supply and demand projections show a supply shortfall of 600,000 bpd in Q3, even assuming OPEC increases output by 1.2 million barrels per day in the coming months. They believe that shortfall could narrow to 300,000 bpd in Q4 if Saudi can raise production to 9.5 mbpd, Angola 1.7 mbpd and Iraq 3.0 mbpd. That may be wishful thinking.

There is an OPEC meeting in June to discuss production quotas. We heard on Thursday that OPEC may change their quota system and announce an increase in production. It will be only for show. They are already producing more than 2.5 mbpd over their official quotas so anything less than a 2.5 mbpd increase will be purely political theater. If they announce a 3.5 mbpd increase the level of the actual increase will only be 1.0 mbpd. However, if countries like Venezuela and Iran continue to have the same or higher quotas as they have today then the whole process is even more bogus. Those countries and several others can't even produce up to their quota today so giving them any more production permission is just more theater meant to appease those who blame OPEC for the high prices.

Driving season begins on Memorial Day and the hurricane season on June 1st. Those are just a couple more reasons why oil may not move lower.

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Crude Oil Chart

Brent Crude Chart

One last comment on the commodity crash. The silver ETF (SLV) saw inflows of $726 million from January until last week. Prices rose from $26 to $48 over that period. Last week the ETF saw outflows of $1.2 billion. On Thursday the ETF closed -9% below its net asset value. Since this is the favorite silver vehicle for retail traders it is a clear example of how involved the retail investor was with silver speculation.

Silver ETF

Citibank (Nyse:C) will no longer be the volume leader on the NYSE beginning on Monday. The stock will open at $45 and well over the $4.52 close on Friday. The reason of course is the 1:10 reverse split undertaken by Citi in an attempt to regain respectability. In theory Citi will then be able to pay a dividend with the Fed's blessing. Many stock funds and investment accounts are prohibited from buying stocks under $5 and some can't buy anything under $10. That keeps a lot of buying power sidelined with Citi stock under $5.

Obviously nothing changed overnight at Citi and this is only a cosmetic fix to an age-old problem. There is nothing to prevent shares of Citi from plunging after the split. AIG did a 1:20 reverse split to avoid delisting in 2009 and they declined after the split. Citi currently has 29 billion shares outstanding. After the split that will drop to 2.9 billion. Citi posted $10.6 billion in profits in 2010 and CEO Pandit expects $20 billion in 2012. Citi Chart

Berkshire Hathaway (BRK.B) is not having a good year. First there was the problem with David Sokol and the insider trading and Buffett was beat up over that at the annual meeting last month. On Friday they reported earnings that declined -58% to $1.5 billion for Q1. That is down from $3.6 billion in the year ago quarter. The company took a $1.7 billion hit for insurance losses related to quake damage in Japan, the New Zealand earthquake and the floods in Australia. Berkshire said given the potential for hurricanes in the U.S. this year it is unlikely the insurance unit will achieve a profit in 2011.

Berkshire Chart

Priceline reported earnings of $2.66 per share compared to estimates for $2.46 and beat on revenue. However the stock lost -$14 (-3%) on the news. The Goldman analyst cut her rating from buy to neutral saying "the anticipated deceleration" in their online business "may arrive sooner than expected." She feels the rising market share Priceline has seen in recent years is coming to an end. Priceline's share of hotel bookings in Europe is approaching 50% and given the number of competitors she sees it topping out soon. Priceline also said Q2 international growth will decline from 80% in Q1 to 56% in Q2. Priceline is moving from a strong growth company to just a company with moderate growth in what is now an established business model.

Priceline Chart

Intel and Apple were in the news amid the rumors of a potential breakup of their partnership. The rumor has Apple switching to ARM chips in its laptop computers and dumping the Intel processors. While this has been rumored there is no confirmation. Reportedly Apple is waiting for the next generation of ARM chips with 64bit addressing capability before making the switch. That update is expected in Q4-2012 to Q1-2013. Obviously it is not going to impact Intel sales any time in the near future. Intel is also working on a competitive chip to the ARM processor and could have its own chip in place before ARM.

Other analysts believe Apple won't jump to ARM because Intel is the mainstream and they continue to be the leading edge of computing. Intel just announced its Tri-Gate transistor technology that will produce smaller, faster chips that will consume less power. That is exactly what Apple will need for its next version of laptops. Intel's stock declined slightly on the news.

Another interesting story for the tech sector is a massive surge in components orders since the earthquake in Japan. The "just in time" supply chain of the last decade has changed. PC makers of all types plus TV and mobile phone manufacturers have seen the slowdown in parts to automakers and some electronics manufacturers and they don't like what they saw. In recent years manufacturers ordered just enough parts to manufacture products for days to maybe a couple weeks at a time. By ordering smaller amounts to be delivered continuously they reduced the cost of inventory and were able to upgrade to new models or different suppliers almost instantly.

After seeing parts for nearly every U.S. product slow to some extent because of the quake in Japan they are changing their order patterns. More than 22% of all chips used in the U.S. come from Japan. Despite the recent mega-quake scientists are predicting another major quake within the next ten years. This has prompted manufacturers to increase orders significantly on Japanese parts so companies won't be shutdown by a lack of supplies when the next quake hits.

This is being called hoarding by analysts and they warn it could impact profitability in future quarters and mask a slowdown in PC and electronics sales. Inventorying hundreds of thousands of parts costs money and reduces flexibility. Analysts predict sales growth of the manufactured products by monitoring sales of the components. The rapid increase in component sales for backup inventory will make that task more difficult. Also a slowdown in component sales could mean a slowdown in product sales or simply that inventories became too high. I suspect this component hoarding will run its course pretty quickly. The disadvantages in the long run far outweigh the advantages. Once the quake headlines disappear and inventory balances begin to weigh on earnings I believe companies will return to the just in time method but they will buy from multiple sources in order to protect their supply chain from a localized event. Meanwhile the component makers are being besieged by monster orders. That has to be encouraging for them.

The Greek tragedy playing out in Europe helped to roil the markets again on Friday after an article in the German magazine Der Spiegel claimed Greece was going to withdraw from the Eurozone. This caused additional volatility in the Euro but the claim was widely denied by everyone concerned. The claim had taken on additional significance when it was learned there was a secret meeting planned on Friday night with various EU finance ministers including ministers from France and Germany. The secret meeting gave credibility to the rumor. After the meeting everyone continued to deny that a withdrawal by Greece was even discussed.

There is little or no probability that Greece will bail from the EU. Because of their current financial situation they have no access to the financial markets. Their only lifeblood is the $160 billion aid package from the EU and IMF and withdrawing from the Eurozone would end that bailout. What will probably happen is an extension of the terms on the bailout in order to get Greece past the first few years of austerity.

The current austerity program has pushed them into a severe recession where the economy shrank faster than expected. However, that shrinking economy pushed the budget deficit from 9.4% to 10.5% of GDP. Greece is going to end up with loans of more than 150% of GDP and a debt problem that almost everyone believes is insurmountable.

Most analysts believe Greece and Ireland will eventually default and be forced to restructure their debt to pay pennies on the dollar. That will weigh on the Euro for years to come. The only way out is for the major debt holders, which include France, Germany and the ECB, to exchange their existing debt for securities with longer maturities and a lower interest rate rather than be forced to accept only a partial payment and have to raise taxes on their citizens to pay for the Greek shortfall.

Last weekend I wrote I was hoping for a 2-3% pullback so traders could reload. From the prior Friday's close to Thursday's low at 1330 was a -2.4% pullback. In theory this was the perfect amount of profit taking to keep bullish sentiment alive and allow new buyers an opportunity to enter new longs.

Obviously we will not know if it was a buying opportunity or just the beginning of a bigger decline until several weeks have passed. The economics are clouding up again and there is less conviction the recovery is moving forward. The headline number on the jobs report was bullish but the household employment survey was bearish. These numbers did not have the 62,000 McDonald boost. Those will be in the May report.

Last week as a big week for consumer sentiment. Osama Bin Laden was eliminated along with his plans for a tenth anniversary attack in the USA. Oil prices imploded and gasoline could decline to $3.50 in June. Those should provide a big sentiment boost for consumers but they both came after the completion of the sentiment survey that will be reported next Friday. That means $4 gasoline will be the lead story in that report.

Corporate earnings have taken a significant turn. The first two weeks of blue chip reports were very positive. Once those big cap reports faded the tone of earnings turned progressively negative. It is not that earnings are not decent because they are but the guidance has been questionable for the smaller companies. Analysts have been quick to downgrade on the slightest hiccup in the reports. Even many oil companies reported disappointing results despite triple digit prices.

The earnings parade is slowing and the economics next week are mostly noise. There is little to stimulate bullish sentiment. The aftershocks from the commodity crash could linger for weeks. It was not as shocking as the flash crash last May because it did not hit as many traders. However for the traders and hedge funds it did hit the damage may be long lasting. Equity traders were afraid of the markets for months after the flash crash. Commodity traders are more experienced and quicker to adjust but I am sure it was a mind searing experience for quite a few.

I talked to Leigh Stevens on Friday and we were both of the mindset that the equity declined stopped where it should have stopped. However, I remain skeptical until we see a new uptrend begin. Thursday was a disaster and Friday was the dead cat bounce. Monday will probably see some testing of support and by Tuesday's close we should have a better idea on market direction.

This is the "sell in May and go away" period and there is even more incentive to take profits ahead of the end of QE2 in June. However, if the economic recovery is still on track then there is also a reason to remain invested. Will those reasons over power the coming summer doldrums? The next couple weeks will tell the tale.

The S&P dipped to the support of the 30-day average on Thursday at 1330. The more recognizable support at 1340 held on Wednesday but the commodity crash forced a closing dip below that level on Thursday. Friday saw an opening spike and then a further sell off began at noon as traders began to clean up the pieces of the Thursday disaster. Support at 1340 held again at the close. If this support breaks the next material support level would be the 100-day average at 1304.

S&P Chart

The Dow closed -250 points off its highs from Monday and after a +700 point rally that should be enough to ease the pressure. However, "should" has an entirely different meaning in the stock market. The indexes rarely do what they should or at least not in the timeframe anyone expects. I am still worried that the commodity crash aftershocks could force a test of support at a lower level. The Dow appears unsupported on its current uptrend but then new highs are normally unsupported. The process of breaking out to a new high leaves all recent support in the rear view mirror.

The biggest gainers in the Dow on Friday were CAT, IBM and BA. CAT and IBM were coming off a week of declines and were due for a rebound. Both were lackluster with IBM the biggest gainer at +1.18. For a $170 stock that is pocket change.

I think there was enough discontent over the underlying components in the payroll report that investors were thinking twice about the industrials. Of course the debris from Thursday's commodity crash was still littering the landscape and I am surprised we didn't end in negative territory.

I am neutral on the Dow until we get a couple more days of trading behind us.

Dow Chart

The Nasdaq was relatively insulated from the commodity crash and only gave up -1.6% for the week with the Nasdaq-100 declining only .9%. Compared to the Russell 2000 at -3.7% it was nearly untouched. Support at 2800 held on the Thursday dip and the slide after Friday's rebound held at 2825. I consider this the most bullish performance of the major indexes. The NDX is only about 40 points away from a new high. Considering tech stocks are not normally good performers in Q2 this resilience is bucking a decent headwind.

Cisco could be the challenge to the Nasdaq on Wednesday. Since they already warned you would think any surprise would be to the upside but then they may have not wanted to release all the bad news at once.

Nasdaq Chart

Nasdaq 100 Chart

The Russell may have lost -3.7% for the week but it did it all in the first three days. There was very little drop on Thursday and a decent rebound attempt on Friday. Support at 830 held as well as the 50-day average at 828. The Russell has honored that average several times in 2011.

The Russell remained mostly between 830-840 for the last three days. This gives us a good range to watch for market sentiment. If the Russell moves over 840 it suggests fund managers are not afraid of the summer doldrums. If it falls below 830 I would immediately go to cautiously bearish and below 820 I would be solidly bearish. That 820 support level held for over a week in April. If it breaks we are in trouble.

Russell 2000 Chart

Since the Dow's July low at 9,614 the index had gained +3200 points to close at 12,810 on the prior Friday. There were only three material bouts of profit taking since the July low. Even with that profit taking the index has rebounded +33% in less than a year. That is a lot even when economic conditions are perfect. They are far from perfect today.

Dow Chart

Uncertainty about economics is a major problem. April reports produced a lot of discrepancies suggesting the economic rebound had developed a flat tire. The engine may be intact but there is no power reaching the road. Until the economics show improvement again I believe the worry is going to be weighted towards a second recessionary dip caused by the rising fuel prices. If oil remains reasonable and gasoline really does decline 50-cents into June then we could be fine. However that is a couple of big IFs.

We still have the uncertainty of what will happen to interest rates when QE2 ends in June. QE 1.5 will still be active but that is well below the current rate of buying. QE2 is $60 billion a month and QE 1.5 is $15-$20 billion a month. (QE 1.5 is the reinvestment of the payoff proceeds from earlier QE1 purchases.)

There are a lot of data points ahead and the next 60 days could be a period of consolidation in the markets rather than a continued rally. I believe we are entering a cautionary period rather than a bullish expansion. Investors have been betting on an accelerating recovery for two years now and growth appears to be slowing rather than accelerating. If May's data confirms that slowing then we are in for trouble in the markets. For this reason I think we have entered a trading market rather than a buy and hold environment. Time will tell.

Enter passively, exit aggressively.

Jim Brown

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"You can avoid reality, but you cannot avoid the consequences of avoiding reality."
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