Shares rallied not because the Fed may twist again like it did last October but on hopes of a future QE3 program.

Market Statistics

Investors may be twisting in the wind if they were betting today on a significant change by the Fed when the FOMC meeting ends on Wednesday. The odds for an extension of Operation Twist, the program that started last October and ends next week are only about 35%. Operation Twist is the program that sold short term securities and purchased longer term maturities in order to push rates lower for longer term securities like mortgages.

The FOMC may extend it but analysts believe it will have little impact because the Fed has very few short term securities left in its portfolio. A senior analyst at Compass Bank said Operation Twist was a one shot deal and cannot be continued because of the lack of short term securities. Vice Chair Janet Yellen said the Fed only had $180 billion in 3-month to 3-year securities left in its portfolio. The Fed has to find some other way to hold rates down and that may be a change in the statement to extend even further to possibly late 2015.

Mortgage rates hit a new record low for the week ended June 7th at 3.67% and its sixth consecutive week of declines. Pushing the rates even lower would take a major Fed program and there is no reason for them to take on that kind of criticism just to gain another quarter point. The Fed could announce the sale of its remaining short term securities with the funds being used to purchase mortgage backed securities from Fannie/Freddie and that would push mortgage rates lower.

Traders betting on OT2 could be disappointed on Wednesday. The bigger bet is more than likely a bet on QE3. Nobody really expects a new QE3 program on Wednesday but they may be betting on a signal from the Fed that another QE program is possible.

The Fed is likely to tone down their economic outlook with negative revisions to their forecast and issue a dovish statement that could lead to a new QE program at the end of July if the economy continues to decline. The Fed could elect to give a stronger signal in lieu of an actual change. The Fed could also decide to jump in early because it is easier to avoid falling down a slippery slope than climbing back up one.

The wildcard here is the election. Bernanke could elect to be more aggressive now rather than risk having to act much closer to the election when the Fed could be seen as making a political move.

Goldman Sachs just downgraded their estimates for Q2 GDP from 1.8% to 1.6%. That would be the fourth quarter out of the last five at less than 2.0% growth. With inflation and oil prices falling the Fed may view the situation as low risk for another move.

The Fed may decide that the contagion in Europe is serious enough to warrant preemptive action but that is a long shot today. Greece appears likely to form a conservative coalition and not be forced into a new election or allow the anti-bailout Syriza party to further disrupt the process.

The Fed got some additional economic news on Tuesday that could influence their decision. The Job Openings and Labor Turnover Survey (JOLTS) showed the fewest job openings since November. Hiring fell from 4.33 million in March to 4.175 million in April. The hire rate declined from 3.3% to 3.1%. Job openings declined from 3.74 million to 3.42 million. Layoffs increased by 6.4%.

The negativity in this report was dampened by the fact that it is a lagging report for the April time period. This is simply confirmation of what we have seen in the Nonfarm Payrolls and the weekly jobless claims. The recent decline in the various employment reports has prompted some analysts to lower their jobs forecast for Q3 to no more than 100,000 jobs per month.

Housing starts for May declined to an annualized rate of 708,000 from 744,000 in April. However, single family starts at 516,000 are at the highest rate since December. Housing permits spiked from 723,000 to 780,000 for a gain of +7.9%. That was the highest level in three years. Starts in the western region rose by +14% with starts declining in all other regions. The decline in starts is somewhat seasonal since the warmer winter pulled starts forward into the Feb/Mar timeframe. However, the spike in permits in May shows the impact of spring selling and the low mortgage rates on the housing sector.

The Risk of Recession report for May rose for the third consecutive month to 32%. The low was 22% back in February. The weaker job market, drop in equity prices in May and the fall in consumer confidence weighed on economic projections. The Risk of Recession report tries to predict the possibility for a recession six months into the future. This implies there is a 32% chance of a recession in the U.S. by year end. Some analysts believe the risk is even greater than that.

For the rest of week the FOMC announcement is the biggest event. The odds are very high there will be a sell the news reaction to whatever the Fed decides. The market has been up for four days on expectations of a win in Greece and a positive announcement out of the Fed. Greece should announce a successful bailout coalition tonight as expected and the Fed anticipation will end tomorrow. A sell the news reaction is a big risk.

On Thursday the Philly Fed Manufacturing Survey is expected to show a minor improvement over the -5.8 contraction reading for May. The official consensus is for a +1.0 reading. The unofficial numbers are looking for a further decline. Moody's is expecting a decline to -6.5 and I hear a bank analyst quoting -7 but I did not catch his name. Anything under zero is contraction territory. The cycle high was +12.5 in March. The employment component fell from +17.9 to -1.3 in the May report. That was the first dip into negative territory since last August. Backorders dipped to -9.4 suggesting June's activity level will be subdued.

Economic Calendar

In stock news FedEx (FDX) said slower global economic growth would depress earnings over the next 12 months. FedEx said it would try to make significant cuts in costs in order to make up for any decline in package shipments. FDX predicted full year earnings of $6.90 to $7.40 per share and analysts were expecting $7.39 per share. The company said U.S. growth could be in the range of +2.2%. That was slightly higher than the +2.1% they predicted last quarter. The company said it was selling 24 more airplanes in order to slim down its network as consumers opted for slower and cheaper shipping services.

FDX earned +6% more per package in the U.S. despite a -5% decline in total shipments. FDX said shipments from Asia fell -3.9%. UPS blamed slowing Asian shipments when it reported lower than expected earnings for Q1. The majority of UPS profits also came from the USA.

Earnings for the quarter slipped to $1.73 per share from $1.75 in the year ago quarter. The company projected earnings for the current quarter of $1.45 to $1.60 and analysts were expecting $1.70. FDX shares dipped -1.50 at the open on the news but then rebounded to close up +2.50 on the long term forecasts.

FDX Chart

Microsoft (MSFT) announced the "Surface" tablet on Monday and shares rallied nearly +3% today. The new tablet will come in two models. The RT version weighs about 1.5 pounds and 2.0 pounds for the Pro version. The cheaper model comes with a phone style processor and the larger version has an Intel processor and the ability to run standard Windows programs. The screen size on both is 10.6 inches and larger than most rivals. Storage ranges from 32-64 GB for the RT model and 64-128 GB for the Pro model. Both versions will have USB ports, a feature the iPad, Galaxy, Kindle and Nook do not have. It also has the capability to expand storage with a MicroSD card, something else the iPad does not have. The Surface has an ultrathin keyboard that folds over to protect the tablet in transit or is detachable if not desired.

The tablets are expected to be available in October for the holiday selling season. Microsoft gave no prices and they did not say how long the battery life would be. "IF" and that is a capital IF, Microsoft can actually produce this product in quantity and without major glitches it should be a major competitor for the iPad. It probably won't be an iPad killer but it will be a competitor.

Microsoft Chart

Nvidia shares rallied +7% on news one version of the Microsoft tablet would run on Nvidia processors. A Nomura analyst, Romit Shah, said the tablet could gain traction against Apple because of the Windows components such as the full Office suite and the full keyboard. He has an $18 price target on Nvidia. The iPad has a common flaw shared by the other tablets to date. It is easier to consume content with the iPad than create it. The Surface could overcome that challenge.

Nvidia Chart

Adobe (ADBE) shares fell -1.50 in afterhours trading after they warned of weakening European demand. ADBE reported earnings of 60-cents that beat estimates by a penny but guidance disappointed. The company said it expects revenue to be in the range of $1.1 billion and analysts were expecting $1.13 billion. Revenue growth estimates declined to 6.5% from 7.0%. Earnings expectations are in the 59 cent range and analysts were looking for 61 cents. The declines don't appear to be material but anyone saying "weakness in European sales" is going to be hit by sellers.

Adobe Chart

JP Morgan shares rallied despite CEO Jamie Dimon being grilled again by the House Financial Services Committee. The representatives made fools of themselves again as they argued with Dimon and with each other about things they really did not understand. They got their five minutes of face time on camera and for many of them they probably lost votes rather than gained them.

Dimon was humble at times and hostile at times as representatives criticized him for speaking out on pending regulations and the freedom of speech. Apparently investors liked what they heard. We will have to wait for July 13th for more information on those trades when JPM reports earnings.

JPM Chart

JC Penny (JCP) shares fell to a 52-week low after the new president left after only nine months in office. Michael Francis was responsible for merchandise and the store marketing campaign and left when it did not work out. JCP also took some heat from the Fathers Day ad showing two men playing with children in what some felt was a play to the gay community. Without Michael Francis CEO Ron Johnson now has an even bigger task of revamping the struggling retailer. Johnson was previously successful at Target and Apple and is seen as the potential savior of JCP.

JCP Chart

Iran and the six UN nations ended talks aimed at getting Iran to quit enriching uranium. To say the talks ended on a hostile note would probably be an understatement. No further talks have been scheduled and the EU embargo and U.S. sanctions will begin as scheduled on July 1st.

The Iranian negotiator, Saeed Jalili, told reporters that "Iran had an inalienable right to enrich uranium at any level it chose." Jalili complained repeatedly that the sanctions were illegal and there would be no agreements until they were dropped. Since the six UN nations want all enrichment to stop and supplies shipped to a neutral third country there was no agreement at any level. The UN nations said they needed to report back to the UN and "parse the comments" to see if there was any common ground to schedule any future discussions. The two sides did agree to have the IAEA meet with Iranian nuclear experts in Istanbul on July 3rd to make sure both sides understood what the other was demanding. That sounds like a lame attempt to make this week's meeting seem productive rather than actually making progress.

Officials within the six nations while not making any official statements seemed to be saying "call us when you are ready to deal." They said there seemed to be no urgency by Iran to avoid the embargo on July 1st. Cathrine Ashton, the EU's lead negotiator, said "The choice is Iran's. We expect Iran to decide whether it is willing to make diplomacy work."

With the U.S. elections later this year it is highly unlikely that the current administration will do anything that will make it seem they are giving into Iran. At this point the embargo and sanctions appear unstoppable and it will only be after several months of these crippling sanctions that Iran may return to the bargaining table. Iran is also trying to save face in the region by not buckling under to UN demands. Unfortunately for them the UN nations have the embargo vise which is slowly closing on Iran. This is not going to end soon and it probably won't end well.

Brent crude moved to touch $95 and a 17 month low and that was in spite of a sharply falling dollar. The economic worries out of Europe and China are weighing on demand expectations more than any decline from the Iranian embargo.

Brent Crude Chart

The markets continued moving higher and the S&P, Dow and Nasdaq are all positive month to date in June for the first time since 2004. This is not normally a positive month. The move higher was seen as a continued oversold bounce and short covering in front of the FOMC decision. Earnings news has been mostly negative but there has not been that much of it. Companies have been quiet for the most part. Those that have warned have been complaining about sales in Europe and that is no surprise.

The S&P moved over critical resistance on Friday at 1325 and never looked back. The close today at 1357 was just slightly below the 100-day average at 1359. The S&P is trading at a five week high and rallied nearly +100 points (+8%) since the June 4th low at 1266. The S&P is well above any material support and suggests a reversal of sentiment could see a major decline.

S&P-500 Chart

The Dow has posted a similar breakout to come within a point of hitting 12,900 on Tuesday. That represents a +860 point rebound from the June 4th lows and a recovery of 61% of the decline from the April highs. This is a critical Fibonacci retracement level and a potential trouble spot.

The Dow was helped today by strong gains in CAT, UTX, XOM, AXP, BA and MSFT. Wednesday will be strictly Fed related and traders may be taking profits ahead of the announcement.

Dow Chart

The Nasdaq has kicked into sprint mode with three days of strong gains. Apple was noticeably absent from the top 20 leaders list but it was positive at +1.63 after the Microsoft tablet announcement. Google was by far the biggest gainer but there are a lot of symbols in the list most traders probably don't recognize.

The next major resistance for the Nasdaq is 3000 but that is more than 70 points above. The path of least resistance is down at this point unless the Fed were to surprise with some new program. Support is well below at 2850.

Nasdaq Leaders

Nasdaq Chart

The FOMC decision will control our fate on Wednesday. Anything is possible but the odds favor a minimal change to policy or none at all. That could produce a sell the news event as traders take profits from the last week's gains.

For the future the G20 leaders in Mexico agreed on one thing. "Spending, not austerity is the path out of the current crisis." That suggests we are going to see more debt in Europe and more QE programs. If the U.S. does not participate in the QE process the dollar will strengthen significantly and cause U.S. firms even more headaches overseas. I am NOT advocating additional QE in the U.S., I am just reporting. Europe is going to try and prove it can spend its way to prosperity and historically that has been proven not to work. Time will tell if the laws of economics have changed.

Enter passively, exit aggressively!

Jim Brown

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