The markets continued to decline for the third consecutive week as worries over economics, earnings and Europe continue to weigh on investor sentiment.
Despite the three weeks of declines the Dow is only down about 300 points from its high close at 12,810 on April 29th. That close ended a +600 point sprint that began on April 18th at 12,093. We have had three weeks of pain equivalent to a bad scrape on your knee that will not heal. We have not yet seen the "rip off the Band-Aid" intraday decline that would signify a capitulation event and give investors the confidence to return to the market.
Volume late this week was exceptionally low with only 6.4 billion shares on Wednesday, 6.0 B on Thursday and 6.5 B on Friday. Remember, this was expiration week. Volume should have been much higher. The reason for the low volume is the uncertainty in the economy and the choppy market. There is no reason for investors to rush back into positions ahead of the summer doldrums with nearly every economic report showing slowing growth. Retailers were the punching bag this week as they posted lower than expected same store sales and lowered guidance. The consumer is pulling back on spending and the economic ripples are starting to be seen in the monthly reports.
There were no economic reports making waves on Friday. The Regional Employment report showed payroll employment rose in 42 states in April. There were significant increases in employment in 19 states. Only Michigan (-10,200) and Vermont (-2,200) reported significant job losses.
However, in the Mass Layoff report for April the number of layoff events rose from 1,286 to 1,564. The number of workers affected rose +22% from 118,523 to 143,927. Analysts believe this was related to the break in the supply chain from the Japanese earthquake. Many automakers were forced to layoff workers for several weeks until the overseas parts manufacturers began to ship again.
Another report confirming the sudden weakness in the economics was the ECRI Weekly Leading Index. The headline number declined again to 128.7 but even more concerning was the drop in the annualized growth rate to 5.3%. The growth rate peaked at 7.8% back in early April and in only six weeks the outlook as changed dramatically. The growth rate in the WLI does not correspond to the GDP. The growth rate in this report bottomed at -29.7% in December 2008. The WLI is seen as an early warning indicator for changes in the economic cycle. The sudden weakness suggests an economic turning point may have been reached.
Moody's WLI Chart
The economic calendar for next week has three more manufacturing reports plus the next revision of the Q1 GDP. Estimates are for a slight gain in GDP to show +2.1% growth compared to the +1.75% in the last report. There are also three home sales reports but I doubt anyone will be paying attention. The various reports next week are not likely to generate any material investor attention.
This is a holiday week and volume is likely to slow even further as traders close up shop and head out for vacations.
You would think investors were already on vacation by the low volume and the lack of news in the market. The Dow fell -120 at the open because the Euro collapsed. Actually it was the Fitch downgrade of Greece that started the ball rolling. It is becoming increasingly apparent that Greece is either going to default on its debt or the debt will have to be restructured. Once it happens to Greece it will set a precedent for Ireland, Portugal, Spain, etc. This is weighing on the Euro and by default pushing the dollar higher. A higher dollar pressures commodities and equities.
Dollar Index Chart
Investors have no confidence in the current market or the economy. Every little headline is causing a knee jerk reaction like we saw from the Fitch downgrade on Friday. Fitch cut Greek debt three notches to B+ with a negative outlook. S&P currently has a B rating and Moody's a B1 grade. All are seriously into junk status. All have warned they could cut the debt further.
The worry now is not that Greece will actually default on its debt but the country will be forced to change the term to reduce the debt payments. By taking a two-year bond, currently yielding 25%, and change it to a ten-year bond with the same face value it is a technical default even though the face value remains the same.
The big concern is whether the credit default swaps that guarantee the debt would be triggered by change in term. The reason they won't change the face value is to protect all the European banks that own Greek debt. If they don't change the face value the banks won't have to write down the debt and will remain technically solvent. If the CDS insurance is not going to be triggered by a change in term then that would be a windfall for those that sold the CDS contracts and a total loss for those that bought the insurance. S&P said any restructuring of term on the debt would be seen as a "selective default" and constitute a "distressed exchange" and would immediately receive a rating of "SD." The ECB remains strongly opposed to such a move.
Fitch said current implementation of the austerity program and political risks have risen and further austerity measures would be required to meet the 2011 deficit targets. Fitch warned of more downgrades saying, "In the absence of a fully funded and credible EU/IMF program (bailout), the rating would likely fall into the "CCC" category indicating that a Greek sovereign debt default was likely." Greece is being pressured to sell â‚¬50 billion of public property to pay down some of its debt.
The current chapter in this European debt crisis novel would not be that important if there were not three more countries that could follow Greece down the default path. The impact on the euro currency from these sovereign debt problems is pushing the dollar around like a butterfly in a storm. This impacts commodities and equities on a daily basis and has added significantly to our volatility. Personally I could care less what Greece does on its debt because I don't own any. However, a bad decision on the part of Greece or any of the PIGS could cause a sharp decline in our markets and that is why we have to endure the weekly chapters in this saga. Unfortunately it may take a couple years before the ultimate resolution is known. During that time our markets will fluctuate on their own and probably move higher but they will always be subject to the short-term volatility from the euro.
This weekend John Mauldin had an interesting commentary on Greece and the euro that pretty well spells out that Greece will eventually default and withdraw from the Eurozone and the Euro itself will self-destruct. This is far more in depth than my cursory explanation above. You can read it here: One Euro for All?
On Saturday S&P cut its outlook for Italy to negative from stable citing a weak outlook for growth and reduced prospects for slashing its mountain of debt. Italy's GDP for Q1 rose only +0.1% compared to a +0.8% growth in Greece. Public debt is 120% of GDP, up from 100% in 2007, and the highest of any nation.
In the U.S. markets the retailers made all the news on Friday. Gap (GPS) warned after the close on Thursday that earnings would be significantly lower for the rest of the year and the stock lost -17% on Friday. That would have been enough to tank the sector but Aeropostale (ARO) also warned that earnings for Q2 would drop to around 14-cents from prior forecasts of 27-cents. This is the second warning this month. ARO warned on May 5th that earnings for Q1 could be in the range of 20-cents instead of the prior forecast of 37-cents. ARO shares declined -14% on Friday.
Other retailers declined in sympathy with Polo Ralph Lauren (RL) losing -4%, VFC -5%, PVH -5% and AEO -8%. However, Foot Locker (FL) rallied +13% after reporting same store sales that increased a whopping +12.8% thanks to the demand for running shoes. The company reported earnings of 60-cents compared to estimates of 44-cents. Foot Locker closed 650 underperforming stores over the last three years in an effort to streamline sales and increase profit margins. Apparently it is working.
Owners of shares in Linkedin (LNKD) must have been thinking the world might really end this weekend as one preacher in California claimed. Shares were up strongly for the second trading day with a morning spike to $107 after closing at $94 on Thursday. When the prices failed to continue climbing, profit taking finally appeared with LNKD closing down a buck at $93. I suspect that will be the first negative day of many. On Thursday they sold roughly eight million shares in the IPO but the volume for the day was 32 million so quite a few shares sold more than once. On Friday volume was 8.4 million, still some flipping but significantly less. Once the public believes the shares are going to decline the lack of buyers will force that reality to come to pass. Once there are shares available to short on Wednesday it could drop fairly quickly.
The explosion in the price of LNKD has prompted many to start ranking the slate of future IPOs in terms of the Internet bubble stocks back in 2000. The one getting the most buzz on Friday was Russian Internet giant Yandex (YNDX). They will sell 52 million shares at $22 on Monday. Reportedly the order book has already been closed due to the high demand. Remember this is 52 million shares not 8 million so the pop in price could be significantly smaller.
Also there is plenty of risk in the Yandex offering. In the prospectus the company warns that investors are subject to political risk when investing in Russia. That would be an understatement. They also warn the company could be harmed by politically motivated actions or could be hurt by "aggressive application of ambiguous laws." They also say "Many commercial laws and regulations in Russia are relatively new and have been subject to limited interpretation." According to Factcheck there are only five Russian companies publicly traded in the USA. The lack of a rule of law in Russia and the aggressive application of ambiguous laws against international companies like Shell and Exxon over the last decade has made Russia more of an outcast than China.
There are dozens of Chinese companies that trade in the USA. That is not without risk as Yahoo found out last month when Alibaba told them they transferred ownership of Alipay to a company controlled by the CEO without first telling Yahoo, the majority shareholder. Surprise! It will be interesting to see how Yandex trades next week but I will not be a buyer.
Another IPO coming up soon is Freescale Semiconductor. This is a company that was spun off from Motorola in an IPO that raised $1.6 billion in 2004. About two years later it was taken private by a consortium that included Blackstone Management Partners, TC Group, TPG and Permira Advisors for $17.6 billion. Freescale still has about $7 billion in debt from that leveraged buyout. The new IPO expects to raise $1.2 billion, which will be used to paydown existing debt but still leave them with $6 billion in debt. About $100 million will go to the equity partners. Freescale had $4 billion in sales in 2010 but lost $1 billion. Freescale is the biggest chip supplier to the automotive industry. This IPO has been eagerly awaited but I can't get excited given the metrics. Those equity partners are in for a long wait before they get paid back.
Late Friday afternoon news broke of an explosion and fire at the high-tech Foxconn plant in southwestern China. The explosion killed two people and injured sixteen others and shutdown production at the plant. This is material to us because the plant produces iPad tablets for Apple. Reports claim the explosion occurred in the "polishing plant" that is likely a cleaning stage at the end of the production process after devices are assembled. The $2 billion plant was constructed in record time and opened in October to produce 40 million iPads a year. An analyst with Sterne Agee said they were not concerned since Foxconn has 50 assembly lines spread across several buildings and several locations. Apple shares lost $5 on the news.
I wrote on Thursday about the $1 billion offer by Liberty Media (LINTA) for Barnes and Noble (BKS). Liberty offered $17 for BKS. The stock opened on Friday at $18 and closed slightly higher so it appears many investors are expecting either a competing offer or a sweetened deal before BKS is eventually acquired. They put themselves up for sale many months ago but the response has been less than enthusiastic. The offer is probably more a bet on the Nook e-reader than a bet on Barnes and Nobles bricks and mortar storefronts.
The reason for the massacre in the book sector is simple. It is Amazon and the Kindle. Amazon announced this week that since April 1st they have sold 105 e-books for every 100 printed books including hardback and paperback combined. That excludes the four million or so free e-books available from Amazon. Last July Amazon said e-books sold more than hard covers and then in January said they outsold paperback books. To jump in only four months to total more than all their printed book sales is amazing. Sales should only grow because Forrester Research claims e-books are still only 14% of all books sold.
Amazon is expected to announce an Android tablet later this year and you can bet there is a Kindle app on that device. Amazon's lowest price Kindle is now only $114 and putting it in the reach of almost every consumer. Amazon has 950,000 e-books available for sale from 99-cents and the majority are less than $9.99 with no shipping. I love my Kindle and I buy about five e-books a month. That is far more than I used to buy in print. I just wish Amazon would split their stock about 4:1 so normal people could afford to buy options on it.
Time to fill up your gas tank. If you have been waiting for gasoline prices to go down in order to fill up your tank this would be a good weekend to do that. The average price of gasoline has declined about 10-cents from the recent highs to $3.88 per gallon. The Mississippi flood failed to wipe out the 17 refineries in Louisiana and they are operating normally. Cheaper summer fuel blends are now in full production and prices have taken a dip. However, we are only a week away from the kickoff of the summer driving season. It won't take long before prices begin to rise again as demand increases.
U.S. WTI crude futures expired at the close on Friday and that helped push the price of crude to $96 at the open of regular trading but prices returned to $100 by the close. Now that the futures expiration games are history for another month we should see prices stabilize around that $100 level before edging up as the summer progresses and hurricane season begins spewing out the weekly storms. With Brent still holding above $112 the pressure on prices will be to the upside rather than the downside until Qaddafi leaves Libya.
Crude Oil Chart
There are five weeks before the end of QE2. I have read dozens of articles on what we should expect when QE2 ends. Their expectations run the gamut between a market rally to a market crash and a monster spike in interest rates. To be honest nobody knows for sure and that is why we have uncertainty in the market today.
The economy appears to be weakening but we really don't know why. Employment is rising but economic indicators are declining. The Fed is torn on what to do when it becomes time to raise rates. Nobody expects that to be any time soon but it will happen. Some Fed heads want to sell assets first. Others want to raise rates first. It is not encouraging when you see the people in charge arguing among themselves about what to do.
The main point is QE2 may end but QE1 is still alive. They will continue to buy treasuries with the money they receive for the matured QE1 assets. When their short term investments end and they are paid off they will take that money and buy treasuries. That is what is happening now. QE2 is buying roughly $60 billion in treasuries every month and QE1 payoff proceeds are buying another $20-$35 billion. This is the safety valve that will keep interest rates from rocketing higher.
Eventually they will have to end that process as well. They will have to give notice of their intent to end the process and probably wait for two meetings for that notice period to sink in to the market consciousness.
Last week the talk about QE3 accelerated. The closer we get to year-end the more financial headwinds we will face. The 2011 social security tax cut will end and wage taxes will rise by 2%. The slowdown in stimulus spending will accelerate as more stimulus programs end. In theory there will be budget cuts of some form in the 2012 budget that begins in October. That will also produce a drag on the economy of 1.0% to 1.5% of GDP according to some estimates.
Some analysts believe interest rates will remain low for an extended period of time despite QE2 coming to an end. The economy is not moving fast enough to support higher rates. Some believe inflation is unavoidable. It may be but with the economy slipping back into neutral there is nothing to power the inflationary curve. When companies are slashing prices in hopes of getting a tight fisted consumer to spend some money there is no inflation. We are already seeing commodity prices decline due to slowing demand.
The Taylor Rule is an economic formula that the Fed uses to model the appropriate Fed funds target rate. Today the Taylor rule says the Fed funds rate should be a -1.65%. A negative interest rate is obviously not practical so this suggests the Fed may need to take additional action of some sort to further stimulate the economy. Whether that means QE3 or some other form of stimulus is unknown.
The Fed's dual mandate includes low unemployment. In theory the Fed should not raise rates or do anything restrictive until the unemployment rate, currently 9.0% declines to below 7.0%. That is not going to happen for a long time. Get used to that extended period language.
Lastly Bernanke himself said that should the Fed do nothing at the end of QE2 that in itself would be an implied tightening of Fed bias. He has to continue at a minimum the QE1 payoff purchases and if the economy continues to weaken he will have to take some other step. He can't continue to load up on treasuries with the balance sheet already at $2.6 trillion and growing. The Fed balance sheet already represents 18% of GDP. They can't exit in a hurry and especially if the economy is not growing. Expect a new program if economic weakness continues.
The government cannot announce or fund any new stimulus programs. The people are already in revolt with the tea party demanding budget cuts and a new election cycle in full swing. Bailouts and pork projects were never liked by the populace. Stimulus is now a four-letter word for voters. If the economy is still in trouble it will be up to the Fed to provide the stimulus. They better hurry because this current business cycle should run its course and expire just after the 2012 elections. Fortunately an election year is normally positive for the markets. The keyword there is "normally" since this is not likely to be a normal election cycle.
That still leaves us with the market question for next week. Up, down or sideways? Trying to analyze it week to week in this environment is a task left to those braver than me. The charts appear to be pointing lower. We have only declined a little more than 2% from the highs so there has been no real correction yet. Since QE2 was announced there has been an 80% correlation between the market gains and QE programs. That would seem to suggest that the expiration of those programs would produce some negative reactions from the markets. However, the end date for QE2 has been known since November. It may have been debated in the press but the Fed has confirmed it more than once so unlike the uncertainty around the end of the world on May 21st the end of QE2 is certain.
If we are dealing with the herd mentality of the investing public then I think it is safe to assume that 99% of investors have not thought this through. By reading the prior paragraphs you are now more educated than 99% of the investing public. I believe we should anticipate their exit from the market. That does not mean we should rush out and short everything. There is never a sure thing in the market.
I believe we should simply anticipate a potential decline and take smaller positions and exit them early. For the last several weeks I have been signing my commentaries with the "enter passively, exit aggressively" sentence. I mean just that. We should double think any new position either short or long and only make the play if we are somewhat confident of the outcome. Once in a trade we should take profits early and keep tight stops. That is good advice in any market but even more appropriate for the next six weeks.
The S&P bounced off downtrend resistance twice in the last three days and 1340 is now the magic number on the upside. Initial support is the 50-day average at 1325 followed by the 100-day average at 1313. Long-term support is at 1295-1300. Those levels are well above what would be considered a real 10% correction to 1225. That means we can chop around above 1300 for a couple weeks and not break the current trend. A move below 1295 would be a dramatic change in market sentiment.
S&P Chart - 90 Min
S&P Chart - Daily
The Dow has a similar pattern of lower highs and lows. However, support at 12,400 was rock solid on the first test. The 50-day average at 12,383 in conjunction with the round number support at 12,400 could be decent support. The Dow, because it is a blue chip index, is showing more strength than the other indexes. It is defensive in nature to some extent. That won't protect it completely if the uncertainty continues but it should help. The closing lows from April at 12,200 also coincides with the 100-day average at 12,185 so that would be another level where I would expect to see a bounce.
The Nasdaq tried twice to break through the resistance at 2861, which was the 100% gain from the March 2009 lows. Both times it failed. The last failure dipped to 2760 on Tuesday, which just happened to be the 100-day average. The rebound lasted two days before running into what appears to be rock solid resistance at 2825. The Nasdaq chart is slightly different from the Dow but still the same outlook. Support should be the 100-day at 2762 followed by 2700.
The Nasdaq is suffering from big cap shock. Apple lost -5.50, Google -7, ISRG -5, etc. Tech stocks have suddenly fallen out of favor after the mid May rally failed. The Goldman downgrade of the semiconductor sector did not help. Hewlett's ugly earnings also depressed sentiment about PC sales. Cisco trashed the router sector. If it were not for Dell last week I feel pretty sure the Nasdaq would have spent this weekend well under 2800.
The Russell worries me. The 50-day average has already failed and the 100-day is on the verge of failing with a break of support at 820. A break there could easily retest 780. I drew a head and shoulders in pink on the chart but I really don't think that is a valid formation here. I don't think it was distinct enough to qualify but I am showing it for reference. Normally the head is more pronounced and the shoulders wider apart. However, the volume component definitely fits. Volume was low on the left shoulder in the high 800 million share range. It rose to 1.1-1.2 million shares on the head it has fallen back to the high 800s on the right shoulder. Declining volume on the right shoulder is a symptom of exhaustion.
If the Russell falls below the 100-day at 817 I think it will test 780. Fund manager sentiment has not really changed on the small caps any more than it has on the Nasdaq so I don't think there is anything newsworthy here until support at 820 breaks. However, because that would also be a break of the 100-day average I think it would be a market sell signal.
In summary I believe there will be more weakness ahead. I am not looking for a sudden washout but more of a choppy market with minor rebounds and declines. The trend appears to be heading slightly lower. Option expiration pressures last week may have influenced the charts so the next couple days should be crucial.
European event risk will continue to be a nuisance more than a serious problem. The economic reports next week are not specifically market movers but should they continue to confirm a slowing economy the preponderance of the evidence will eventually convict investors to move to the sidelines.
We are at that point on the calendar where I like to use the term "why buy?" Investors, as opposed to traders, have no real incentive to put additional money at risk ahead of the summer doldrums. This year they have even less reason because of the uncertainty surrounding QE2 and the economy. The bad news bulls seem to have gone to the barn because bad news is no longer being bought. Until that trend returns there is no incentive to add to long positions.
I would continue to be cautious. Enter passively, exit aggressively.
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"Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth."