The Fed has been replaced in the headlines by rumors of ECB stimulus moves.

Market Statistics

The saying used to be "don't fight the Fed." That has changed over the last week to don't fight the ECB. The strangest part of the story is that the ECB has done nothing. ECB head Mario Draghi said he would do whatever was necessary to save the euro but outside of talking up the markets there has not been any new programs.

The Dow gapped open again on Friday on comments out of Europe but ran into stiff resistance at 13,000 where it stalled for 2.5 hours. At 1:34 a news story broke saying Draghi was going to hold talks with German Bundesbank president Jens Weidmann in the coming days in an effort to overcome reluctance to new stimulus measures by the ECB. The Dow was sitting at 13,006 with a gain of +115 when the news broke and it instantly doubled to 13,117 and a gain of +227. This was on rumors of talks on potential stimulus programs that might be discussed by EU leaders in the future. Talk about betting on a long shot, this was it.

We know from the past that potential ECB and EU programs rarely come to pass as expected. This is just another example of a heavily shorted market reacting to rumor headlines.

Another headline making the rounds was the possibility of granting a banking license to the European Stability Mechanism (ESM) bailout fund. This is not new but from the market reaction you would have thought it was a novel new idea that would rescue Europe from its problems. Draghi's latest proposal involves the ESM buying government bonds on the primary market along with purchases by the ECB on the secondary market in order to push interest rates for sovereign debt back to record lows. ECB rate cuts and another LTRO program are also up for discussion. The LTRO is the ECB version of QE where the ECB loans money to European banks for 3-years at 1% interest and those banks then buy government debt and make consumer loans with the funds.

Having Draghi talk about possible ECB stimulus measures is equivalent to having Bernanke say the Fed was considering a massive new QE program, extending of operation Twist and cutting the reserve rate to zero at the next FOMC meeting. Talk is cheap but it can move the markets. Today the ECB's best stimulus component appears to be a microphone. However, failure to actually implement those policies at the next meeting would have exactly the opposite market impact. What goes up on rumors comes back down on facts or the lack thereof.

Everyone needs to step back and take a deep breath over the weekend. The Fed has about a $3 trillion balance sheet from already enacted stimulus. The ECB now has about a $4 trillion balance sheet. How much farther can these institutions push the envelope without capsizing and creating an even bigger problem?

Several analysts said late Friday the Draghi comments sounded like panic and desperation over the rapid deterioration of Italy and Spain. We also learned on Friday that Spain has finally conceded it may need a state bailout and has discussed a 300 billion euro bailout with German officials. Spain's 5-year bond yields rose to more than the 10-year yields last week and that is a classic sign the bond market is expecting a default sooner rather than later. Spain is also considering writing down Greek debt to Spanish banks after EU officials acknowledged that Greece is too far off its economic targets to be saved by the second bailout from five months ago. Another 70% write down of the new Greek debt by the ECB and European banks is already being discussed. Greek 10-year bond yields are 27.0% and clearly unsustainable. German officials said they were not comfortable with a full Spanish bailout at this time. Spanish unemployment hit a new record high at 24.6% according to a new report from Spain on Friday. Why are any of these eurozone problems going to get better in the weeks ahead?

Investor sentiment has been at multiyear lows in recent weeks. The second quarter earnings cycle has been the worst since 2009. More than 60% of companies have missed on revenue estimates. Guidance has been horrible for the rest of 2012. Why should the markets be at three month highs? There is no fundamental reason. This is pure short covering and speculation over potential central bank moves in the U.S., Europe and China.

Obviously if we are betting against them the markets can remain irrational far longer than we can remain solvent.

On the U.S. economic front the GDP for Q2 came in slightly higher than expected at +1.54% growth. Analysts were expecting +1.4% compared to +1.96% growth in Q1. The decline from the prior quarter was due the change from rising consumer spending on durable goods in Q1 to a small decline in Q2. Slower growth in fixed investment spending and higher imports also weighed on the total.

The PCE inflation index fell to +0.7% from the +2.5% seen in Q1. The difference was the rapid decline in crude prices in Q2. The core rate of inflation declined from 2.2% to 1.8%. There is nothing in the inflation numbers that will prevent the Fed from adding stimulus next week but the higher than expected headline number at 1.54% could be a deterrent. With many whisper numbers in the +1.0% range and some even below that number the Fed would have had reasons to take action.

The upside surprise in GDP coupled with the expected ECB action on Thursday suggests the Fed will remain on hold next week.

The BEA also published revisions in the quarterly GDP numbers all the way back to Q4-2009. As part of that revision they raised Q4 growth from +3.0% to +4.1% and Q2-2011 from 1.3% to 2.5%. I am sure we are all relieved to know that growth was a full one percent higher in those quarters. The BEA and the BLS are really into this revisionist history. They change numbers for years into the past and nobody ever calls them on the changes but we live or die in the markets by the current weekly posts.

Current consensus estimates project the economy limping along at +2.0% growth or below through 2013 with a recovery beginning in 2014 thru 2016. That assumes the eurozone does not self destruct and China remains an emerging economy.

GDP Chart

The final Consumer Sentiment for July came in at 72.3 and only slightly improved over the initial reading of 72.0. This is still the lowest reading since December and the second consecutive decline. The expectations component was the biggest drag with a decline from 67.8 to 65.6. Analysts believe that gasoline prices helped to boost the revision as consumers got a break on the cost of vacation driving.

Consumer Sentiment Chart

There is a very busy economic calendar for next week and there are some very important events. The ISM reports will give us an update on the national activity levels. The payroll reports will confirm the ISM with the ADP on Wednesday and the Nonfarm report on Friday. Estimates for the nonfarm report are for a gain of +100,000 jobs compared to +80,000 in June and an average of +75,000 over the last three months.

The Fed meeting on Tue/Wed is going to be a key inflection point for the week. Analysts are very mixed on what, if anything, the Fed will do at this meeting. The majority still believe the Fed will not make any major change in August and will wait for the September meeting so they can see another month of economic reports. A Fed announcement without any changes to stimulus is not going to be received well by the market.

The ECB meets on Thursday and they are expected to announce some new stimulus program. Many believe they will announce another round of LTRO or Long Term Refinance Opportunity. The two prior LTRO programs of roughly 500 billion euros each helped stabilize interest rates in the eurozone for several months as the banks participating in the LTRO, 523 in the first one and 800 in the second, used the new money to go shopping for sovereign debt. Getting a three year loan at 1% from the ECB and using it to buy sovereign debt of less than three years and yields in the 3% to 5% range was a golden opportunity for European banks.

You have to wonder if a third tranche would work as well. The first tranche in December worked great to bring yields down. The second tranche in February worked well but not quite as effective as the first. Those were almost back to back and it has been five months since the last one so a third tranche might buy the eurozone another 60 days of relative calm. Would it be worth the price since Spain's debt, the biggest problem today, has been removed as an acceptable asset class by the ECB? Time will tell.

The key point here is that the FOMC announcement on Wednesday and the ECB announcement on Thursday will be pivotal events in the market.

Economic Calendar

I really hate to keep reporting on Europe but when our market seems to be reactive to every headline it is hard to just ignore it.

On the earnings front the big news of the day was Facebook (FB). They reported adjusted earnings on Thursday night that were in line with estimates at 12 cents. On a GAAP basis they lost -8 cents. Revenue was roughly in line but disappointing. Customer growth was disappointing as was spending. Spending increased +60% in Q2 and they said it would grow even faster for the rest of 2012. Meanwhile advertising revenue growth in the U.S. grew by 25% in Q2 compared to +97% in Q2-2011. Facebook is being hurt by the move to smartphones and away from desktop viewing. Ads cost less on mobile platforms and they are less likely to be clicked.

With user growth also slowing and revenue growth slowing it is no surprise the company did not give any guidance. That also frustrated analysts and caused several to assume the worst. Face book currently has 633 million shares available to trade and 123 million traded on Friday. They have a share lockup expiring on August 15th for another 268 million shares or basically a 42% increase in shares. Odds are good we are going to see FB trade lower around that event. FB shares dipped to a new low on Friday at $22.28 intraday and a close at $23.71.

Facebook Chart

Chevron (CVX) posted earnings of $3.66 per share or $7.21 billion but that was still a decline of -7% from the year ago quarter. Analysts had expected $3.24 per share. Declining production and falling prices in Q2 had a major impact on revenue. Chevron is not alone. Shell (RDS), Occidental (OXY), Conoco (COP) and Exxon (XOM) all saw profits decline. Exxon had a one-time gain from an asset sales that clouded their numbers.

Chevron saw Q2 production decline from 2.69 mbpd to 2.62 mbpd. The company also warned that full year production would be below prior guidance of 2.68 mbpd. Slowing production was a shutdown of the 60,000 bpd Frade field in Brazil and maintenance work at the 300,000 bpd Tengizchevroil plant in Kazakhstan. Chevron is still fighting spill claims in Brazil over a minor offshore spill of 3,000 barrels. That dispute has shutdown production in the Frade field. Until that is resolved meeting production targets will be a challenge. Dow component Chevron gained +1.00 on the news.

Chevron Chart

Drug maker Merck (MRK) gained +4% after posting earnings of $1.05 compared to estimates of $1.01. Profits rose +9% despite some revenue declines as generic drugs take their toll. The company still managed to generate profits of more than $3.23 billion plus another $1.71 billion from asset sales. The earnings report sent shares of Dow component Merck to a new four-year high at $45.10.

Merck Chart

Starbucks (SBUX) reported earnings of 43 cents Thursday night that disappointed investors. Analysts were expecting 45 cents. The company still made $333 million during the quarter. Starbucks cut estimates for the next quarter to 45 cents from 47 cents and analysts were expecting 48 cents.

Global same store sales rose +6.0% compared to estimates of 6.1%. Sales in the Americas rose 7% and China +12% but sales in Europe, Africa and the Middle East were flat. The CFO said on the call "Europe continues to be our most challenged part of the world by far. The European economy is extremely challenging and perhaps worsened during the quarter."

Starbucks has 17,400 locations worldwide with 10,800 in the USA. CEO Howard Schultz said they were opening 600 stores in China this year.

I am very bullish on Starbucks. I believe the bakery business they just bought is going to help considerably and they are just getting started in the premium juice business. The company may be experiencing some slowing in sales growth in Europe but eventually the global economy is going to improve and Starbucks is still in global growth mode at +1,000 stores per year. I believe this is a buying opportunity for investors with a long time horizon.

Starbucks Chart

The biggest loser of the day was Green Dot (GDOT). They are an issuer of prepaid MasterCard and Visa cards. They went public in 2010 at $36. Prepaid cards are growing in popularity for those with credit problems and no bank accounts. Earnings were 35 cents and analysts were expecting 38 cents. Revenue rose +19% to $136.7 million compared to estimates of $142 million. Operating costs rose +23%.

The problem came from the lowered guidance. The company said it now expects to earn $1.29 to $1.32 compared to a prior forecast of $1.65 to $1.70. Analysts were looking for $1.69. The company said it lowered guidance on uncertainty about increased competition. Netspend (NTSP) is gaining ground by offering branded private label cards and competition is heating up. Shares of Green Dot fell -61%.

Green Dot Chart

The biggest gainer on Friday was Priceline at +$55 after Expedia (EXPE) posted decent earnings. Priceline does not report until August 7th and some analysts believe it remains better positioned than Expedia. Expedia gained +20% on the earnings news. The company reported earnings of 83 cents compared to 12 cents in Q1 and 69 cents in the year ago quarter. They beat estimates by 12 cents. Revenue rose +27.4% sequentially and +13.8% year over year. Despite the lagging global economy the online ticketing business is booming.

Expedia Chart

Priceline Chart

Amazon (AMZN) shares rebounded +17 the day after earnings disappointed some analysts. Earnings were only one cent, a 96% decline and the biggest drop since 2002. Analysts were expecting three cents. They also guided to an operating loss of up to $350 million in the current quarter and for sales as much as $1 billion below analyst estimates for Q3. Why is Amazon up +17 instead of down -17? The reason given was the high rate of investment across all of Amazon's businesses. They completed six new distribution centers and each one costs to build and staff and then fill with inventory. Analysts believe these investments will pay off in the coming holiday season when Amazon has more inventory and faster distribution capability. They are also investing in a new version of the Kindle Fire and on increasing their digital inventory of books, music and movies. Eventually Amazon will have to produce some real earnings but analysts have been saying that for years and they just keep building.

Amazon Chart

Google shares rallied $21 to $635 after they announced Google Fiber, a superfast Internet/TV service in Kansas City. The service offers access speeds at 100 times those of traditional cable services. The service will offer the ability to record up to eight TV shows at a time and store up to 500 hours of HD programming. The base service comes with more than 100 channels of TV, 1 gigabyte per second download speeds and 1 terabyte of cloud storage. (1,000 gigabytes) That is 20 times faster than Time Warner's network. Networks available will include Comcast NBC, Discovery, Viacom, CNN, TNT, TBS, Disney, ESPN, etc and premium movie networks from Liberty Media Starz for an additional fee. The service is not cheap at $120 a month for the base service plus a $300 installation fee. They are offering a Google Nexus 7 tablet as a voice activated remote control to early users. If the service catches on it would take a long time to populate the service to other major cities. Google has long said they wanted to offer broadband to everyone but I doubt everyone can afford this price.

Google Chart

Apple (AAPL) has recovered about $15 of its $35 post earnings drop as of Friday's close. Analysts are juggling their earnings revisions and trying to decide if the earnings miss was just a product cycle problem or an iPhone problem. Apple sold 26 million iPhones in the quarter compared to 50.5 million smartphones sold by Samsung. The Samsung Galaxy 4G phone has become extremely popular. The iPhone 4S is not 4G. Apple is expected to announce the next generation iPhone in September or early October. That will flood the fourth quarter with massive deliveries but analysts are unsure how to project sales for future quarters. Has Apple run out of tricks? Only time will tell.

Apple Chart

Earnings for Q2 have been a mixed bag. So far 67% of the S&P-500 reporters have beat on the earnings side. Only 22% missed on earnings. However, 60% have missed on revenue and the majority have lowered guidance for the rest of 2012. In a survey by FactSet 47 out of 60 blue chip companies lowered earnings guidance for Q3. Average revenue growth for Q2 has been 2.3% compared to the ten-year average of 7.1%.

The official S&P estimates for Q3 have now gone negative at -1% expected growth and the earnings cycle has a long way to go. On July 1st the Q3 estimates were for 3.1% growth and on April 1st analysts were expecting +11%.

Q2 profits are up about +6.1% with 291 of the S&P already reported. That is significantly better than the forecast just three weeks ago but the final tally is still expected to show a -1% decline according to S&P Capital IQ. Companies have definitely surprised on the earnings front thanks to a steady diet of cost cutting as economic conditions worsened but sales are declining for the majority of businesses.

In theory the markets should be in a state of despair given the weak outlook but apparently nobody is paying attention. Art Cashin pointed out that anyone focused on specific stocks and ignoring the market fundamentals would have done pretty well over the last month. The market in general has been very volatile with eight awings of about 400 Dow points in the last seven weeks. Unfortunately those sprints have all been in alternate directions. We have gone from elation to panic and back multiple times while the economics, earnings and European stories have played out.

On Friday another short squeeze came on the backs of not only the Draghi comments but others in the EU. Angela Merkel and French president Hollande issued a joint statement saying they were "determined to do everything necessary to protect the eurozone." When those comments were added to the Draghi comments about doing whatever was necessary the expectations for strong action began to grow.

Since Germany will end up footing the bill for any future bailouts the Merkel/Hollande statement was a major upgrade to EU sentiment. She still has to get past the Bundesbank and win support of German lawmakers and that may be a tough task. Bundesbank president Jens Weidmann tried to calm the markets late Friday saying the meeting was not special. He meets with the ECB regularly to discuss all sorts of topics.

I believe the market has gotten ahead of reality. The expectations for some monster resolution in Europe have surpassed what can be accomplished. The ECB still has the biggest club in its ability to print money but Germany still has the reins and several other countries have come out against further stimulus in just the last couple weeks.

The market tends to react to headlines without thinking through the process. What we have here is a case of irrational exuberance on the part of traders. This is not a situation where one or two people can unilaterally act on impulses. This is a group of nations with very different views and responsibilities. The headlines may be able to create short term short squeezes but there will be an eventual need to backup the headlines with action.

That brings us to next week. The ECB through Draghi has built up some strong expectations for action at the Thursday meeting. A lack of any concrete action could be seriously market negative. We have seen in the past where an announced plan to make a new plan would support the market for several days. I am not sure that will work this time around. Every verbal injection of hopium into the market is followed by a high that is shorter in duration. The sugar rush is turning into a dependency rather than a treat.

The Federal Reserve has also created its own expectations by NOT debunking the WSJ article last week. Bernanke listed some of the actions the Fed could take during his testimony to Congress and then the WSJ pumped up the market by repeating the list just as bearishness was about to get out of hand on Tuesday. The Fed members could have talked that down but they were in the quiet period before the meeting so the response was minimal. Now they have that expectation to overcome.

The Fed and ECB can't afford to disappoint the market next week. However, the ECB may have let the Fed off the hook if they follow through on Draghi's "whatever is necessary" comment. Unfortunately the Fed meeting ends before the ECB begins.

The Fed has very few arrows left in their quiver. They could maximize the impact of those arrows if they acted in conjunction with the ECB and EU this week. If they announced some sort of coordinated action it could be explosive. I am not holding my breath but it is possible.

I suppose that brings us to a major inflection point for the market next week. Talk is cheap and now it is time for these central banks to show us the money or in this case the stimulus. Kicking the can down the road another month could produce an unpleasant reaction.

The S&P gapped open on the joint comments from Merkel-Hollande and then stalled at resistance at 1375 at 11:AM. The index traded in a narrow 3-point range for over two hours with only a slight upward bias. The explosion at 1:25 came on news the ECB and German Bundesbank were meeting next week. Just before the close in an effort to dull the report the President of the Bundesbank told reporters the two banks meet routinely to discuss a range of issues. The rally faded on those comments to close at 1385.

The monster short squeeze on Thr/Fri exceeded any move I expected. I was definitely bearish at Tuesday's close and I suspect about 75% of market participants were expecting the same thing. The unexpected comments from Draghi on Thursday and Merkel/Hollande on Friday were like a water mirage to a hiker dying of thirst. The two days of gains eclipsed five days of declines. Short squeezes are really fun to watch as long as you are not short.

The real key will be what happens next week. Since the market direction will not be guided by fundamentals, anything is possible. There is significant resistance in the 1400-1405 range but just touching that level will be bullish. Seeing a 14 handle on the S&P will convince many investors to come off the sidelines and convince any remaining shorts to cover. Terminal resistance is in the 1420-1425 range. This should be very strong and a break through this level for any reason could set off a huge bout of buying.

This is month end so the sudden upward bias should have many actively managed funds looking to be long at Tuesday's close. That does not mean they won't be getting short or flat again on Wednesday but they will need to be long the market if the S&P is threatening to move over 1400 by month end. This is where the rally becomes self-propagating.

S&P Chart - 2 Min

S&P Chart - Daily

The Dow clearly exceeded my expectations for a stall at 13,000. The Dow gapped up, moved sideways at 13,000 for over two hours then exploded to 13,117 before fading at the close. Without the Bundesbank meeting headline I believe it would have failed at that 13,000 level. After the second spike we had new resistance form at the 13,100 level. It was as though the bears fell back to regroup at the next 100 point marker.

The break through 13,000 sets up a retest of stronger resistance at 13,275. The new high at month end scenario could keep the short squeeze going but it depends on the headlines.

Dow Chart - 2 Min

Dow Chart - Daily

The Nasdaq ran for a 2.2% gain on Friday and the biggest gain of the major indexes but it is still lagging on a relative basis. So far it has failed to exceed the highs from the prior week at 2976 and remains well under stronger resistance at 3000 that equates to Dow 13,000.

Coinstar (CSTR) and Starbucks (SBUX) were the biggest losers at -13 points collectively and they were offset by +115 points gained by the top five gainers. It was a significantly lopsided day but the index still failed to catch up with the Dow and S&P.

Top 20 Nasdaq Winners and Sinners

Nasdaq Chart - Daily

The Russell posted a strong rebound because small caps were the most heavily shorted stocks earlier in the week. The 796 close is well below resistance at 810 and that should be the key level to watch. The small caps have been relatively volatile with no particular trend. I would watch for a failure of the rebound at 810 as an indication the headlines have lost their impact on fund managers.

Russell 2000 Chart - Daily

Last weekend I pointed out the doji on the TSMI chart on the 19th as a potential topping indicator. The next three days seemed to confirm but headlines overruled fundamentals on Thr/Fri and we are right back at the resistance highs again. The small move over 14,375 could be a head fake. Coming on a Friday that is not enough to confirm a breakout on the largest stock market index. Watch carefully for confirmation or rejection.

Dow TSMI Chart - Daily

Next week is going to be a major inflection point for the market. With month end on Tuesday, ISM and FOMC on Wednesday, ECB on Thursday and Nonfarm Payrolls on Friday the market will be headline driven. Fundamentals will not matter. The market could be 500 points higher or lower by Friday's close and nobody today knows what direction it will take.

The central banks can't afford to disappoint the market but the Fed has no bazooka rounds left in its arsenal and the ECB does not have enough support to unilaterally drop a bunker buster on the European crisis. Unless they can figure out a way to put a reasonable ceiling on interest rates for sovereign debt for the PIIGS the problems will continue. Greece is going to default again and Spain is not far behind. It is time for strong action out of the ECB but do they really have the will to "do whatever is necessary?"

I would bet we finish the week lower but my bias is probably clouding my judgment. The two points that could change my opinion would be a decent uptick in the ISM and a sharply higher payroll number.

Enter passively, exit aggressively!

Jim Brown

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"If you don't know where you are going, you'll end up someplace else."
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