Worries over conflicting views on tapering QE3 put the market into a stupor.

Market Statistics

The volatility surrounding the Bernanke testimony and the FOMC minutes evaporated by noon on Friday and traders leaving early for the three-day weekend left the market in a coma. Volume slowed to almost nothing at barely five billion shares as the major indexes gravitated slowly back to unchanged as shorts covered before the holiday weekend.

The Dow actually closed positive with an 8 point gain after a -95 point drop at the open. The Nasdaq and S&P lost a fraction of a point at -0.28 and -0.91, respectively. The Dow Transports were the biggest losers at -34.

There was only one economic report on Friday and that was the Durable Goods orders for April. Orders rebounded +3.3% on the headline number, up from a decline of -5.7% in March. However, if you take aircraft orders out of the mix the gain was only +1.3%. Shipments fell -0.6% and inventories rose +0.4%. Shipments of core capital goods fell -1.5%.

The headline junkies thought the +3.3% rebound was strong and it was better than the +0.5% expectations but you have to factor in the orders Boeing received for planes to be delivered 2-5 years from now. An order for a 787 to be delivered in 2017 is not going to impact the manufacturing economy or jobs anytime soon. I view the report as neutral.

The economic calendar for next week is moderate with the Richmond Fed Manufacturing Survey and the Chicago PMI the highlights for information on current economic conditions. The Q1 GDP revision on Thursday could be a challenge if the revision were to fall under +2% from the initial estimate at +2.5%. Analysts believe it is going lower but how much is up for debate. The GDP for Q2 is expected to be 1.7% to 1.9%.

There is really nothing to get excited about for next week. The market should be slow as the first official week of summer and volume is expected to be light. The economics are not expected to provide much in the way of volatility.

Economic Calendar

Weighing on our markets last week, in addition to the Fed events, was a bad PMI number from China and a huge -12% move in Japan's Nikkei index. The HSBC flash manufacturing PMI for China for May came in at 49.6 compared to expectations for 50.4. That is a 7 month low and shows China to be in a contraction phase rather than expansion. The new orders component also fell into contraction at 49.5 and the lowest reading since September. The PMI report hurt the commodity sector as expectations for demand declined.

The government version of the Manufacturing PMI will be released Thursday evening. Because it is a Chinese government report it will likely be stronger than the flash PMI we got last week. Chinese governmental numbers tend to be overstated. China's full year GDP is expected to grow by +7.5% and that would be the worst performance in 23 years.

The Japanese Nikkei declined -12.5% from peak to trough on Thursday and ended with a -7.3% drop. This is the 10th time in the last 50 years the Nikkei has declined more than 7% in a single day. The -1,143 point decline was the equivalent of a -1,117 point decline on the Dow. Friday was not much better with a -500 point decline at the open but a rebound to close with a +127 point gain. How would you be feeling this weekend if the Dow had seen a -1,700 point move in the last two days? Markets can move suddenly against the trend. The Nikkei lost more than $314 billion in market cap on the two-day decline.

Nikkei Chart - Daily

The markets were all a twitter over the contradictory remarks from Bernanke and the disagreements among the participants in the FOMC minutes. The markets were shocked to hear that QE purchases could slow as soon as the June meeting. The rest of that sentence said if job gains continued and economic conditions improved in line with Fed guidelines. Since that is not likely to happen the worry was misplaced.

Some feel the Fed speakers are being purposefully vague and contradictory. By creating confusion in QE expectations they are restraining the equity markets to avoid an asset bubble. The Fed always wants to avoid having the market assume a particular condition will last for a long time because hedge funds can then bet with or against the Fed and cause an undesirable market reaction. The Fed may be all about "improving communication" compared to the Greenspan era but sometimes too much communication is a bad thing.

The Fed currently owns $1.583 trillion in ten-year treasury equivalents. That means they own 30.32% of all ten-year treasury paper. Private sector ownership has fallen to a record low of 69.68%. The Fed is effectively monetizing the U.S. debt. With the 2013 deficit shrinking the need for the government to sell more debt is also shrinking at least temporarily. That means if the Fed continues its QE program it will be extracting treasuries from the secondary market without any new treasuries being sold. That means the percentage of all treasuries held by the Fed will begin to accelerate sharply. If the current rate of Fed purchases continued they would own 45% of all treasuries in 2014, 60% in 2015 and 90% in 2017. Clearly the Fed is going to reach a point in 2014 where they will have to halt of modify their purchases even if the economy has not recovered. The Fed can't allow itself to continue to increase its total percentage of government debt.

Secondly, the global financial community will not allow it. There will eventually be another major downgrade by the ratings agencies and the associated rise in interest rates even with the Fed purchases continuing. The ratings agencies are not going to let the Fed continue to monetize the debt indefinitely.

The Fed will get some help from the government. The deficit, although shrinking this year, will continue to be a deficit and even at $600 billion a year it will require the sale of that much in new treasuries. Supply will continue to increase although at a slower rate.

The following chart shows the current durations of marketable treasuries with the black lines those held by the Fed.

Stone & McCarthy Research Chart

In stock news there were only a few events on Friday. Sears Holding (SHLD) declined -14% costing Eddie Lampert $467 million for the day. Lampert only receives $1 per year as salary since he took over as CEO of Sears on Feb 1st. He controls 55% of SHLD shares. However, he will receive $4.5 million in Sears stock per year. The company reported a Q1 loss of $279 million compared to a profit of $189 million in the year ago quarter. The loss was -$1.29 per share compared to estimates for -60 cents. Sears said costs for store closings and employee severance expenses hurt earnings along with poor weather and weak economic conditions. The company currently owns 1,211 Kmart stores and 851 Sears stores. Same store sales at Sears declined -3.6% and Kmart -4.6% and overall revenue declined -9% primarily due to closed stores and stores that were sold.

Sears Holdings Chart

Abercrombie & Fitch (ANF) reported same store sales declined -15% and Aeropostale (ARO) reported a -14% sales decline. These teen retailers have been slow to react to the need to change to the new looks in the quick changing teen fashion world. Weak consumer trends mean slow sales and high inventory levels and retailers are hesitant to slash prices to flush inventory and then spend millions buying new looks that might also be hit by the weak sales environment. Shares of ANF and ARO declined sharply on the news.

Abercrombie Chart

Aeropostale Chart

Salesforce.com (CRM) declined -5% on Friday after posting earnings of 10 cents compared to estimates for 12 cents. Revenue of $893 million fell short of estimates of $935 million. The CEO said they experienced severe currency headwinds with regard to the Japanese yen. When yen payments are converted back to dollars the value has been dropping sharply. Salesforce is fresh off a 4:1 stock split in mid April that brought the stock back into the range for normal investors at $44. Several analysts were quick to reiterate a buy on CRM after Friday's drop.

Salesforce.com Chart

Gamestop (GME) reported earnings of 46 cents that beat estimates of 40 cents but revenue of $1.87 billion was weaker than expected. The company raised full year estimates by a few pennies to $2.93-$3.15 but it was not enough to escape the Xbox curse. Microsoft announced the Xbox One earlier this week to rave reviews and it is clear the trend is moving even faster to online games. Amazing Microsoft Xbox One Announcement Video I think the new Xbox is even going to be a challenge for Apple TV. If you watch the video I think you will see what I mean. Analysts were quick to question the potential for the used game market in the future and Gamestop, which makes a market in used games, immediately declined. Shares of GME fell another -11% on Friday.

Gamestop Chart

The earnings cycle is over now that Hewlett Packard and Cisco have reported. They are typically the latest reporters of the major companies. About 67% of the S&P beat on earnings but only 41% beat on revenue. Guidance warnings for Q2 were rampant with companies lowering estimates at the fastest pace since 2001. The market ignored the guidance because the Fed was supplying the joy juice at the fastest pace in history. Eventually the economy will find some traction and companies will be raising estimates. By that time the Fed will need to reduce or end QE and the market will crash despite the better earnings news. If you want logic don't look in the equity market.

The rampant QE by the various central banks should be pushing currencies lower and commodities higher but lack of demand due to declining global economics is fighting that trend. When the Nikkei crashed on Thursday the price of gold rebounded to $1413 because suddenly the safety of equities was called into question. The rebound did not last long with the close on Friday at $1386. Global dealers claim purchases of physical gold are running 9:1 over sales since mid April as buyers take advantage of the cheaper prices. Purchases were 4:1 over sales during the first quarter. In a Bloomberg survey last week 12 analysts were bullish, nine bearish and eight neutral. That was the highest proportion of bulls since April 26th. "When" the equity market eventually corrects we could see a major short squeeze in gold. Until then owners of gold will continually fear the breakdown of support at $1360 with some analysts calling for $1200 before the bear market ends.

Gold Chart

The market blinked last week. After five months of gains the two day intraday dip of -1,961 points (-12.3%) on the Nikkei shocked some bulls out of their complacency. While nobody but Harry Dent believes that could happen in the U.S. the bulls had to at least consider the potential for a few seconds.

The resulting -346 point dip in the Dow from the Wednesday high to Thursday's low was a wakeup call for investors. The Thursday morning dip was bought as was the Friday morning dip but the volume was anemic and the rebounds lackluster. The bloom may be off the rose but I doubt it will be this simple. Factor in the desire to be cautious over the long weekend and that could have been the reason for the soft rebound.

On the bright side everyone has been looking for an entry point. Last week was the biggest dip since the mid April slide. In theory everyone has been waiting for a dip as an entry point. Now it will be interesting to see if they buy the dip or run and hide under the covers like scared children after a Dracula movie.

The S&P declined to 1,635 on Thursday and 1,636 on Friday. That should be enough to give us a decent guideline for trading next week. Any further move under 1,635 would tell us this is not a garden variety 2-3 day bout of profit taking. We have the additional warning of the lower high on Friday and the outside reversal signal on Thursday. An outside day is one where the intraday price exceeds the prior day's high significantly and then closes below the prior day's low. This is typically a trend reversal signal when it occurs at new highs. Obviously this was due to the abundance of headlines but it is still a valid signal. Technical analysis does not care why a chart event happened only that it happened.

If we were to get another lower high and lower low on Tuesday it would be technically negative. This is especially true because Tuesday's after a holiday weekend are normally bullish. The last week of a month is normally bullish and we have the Dow 20 trend to hold us up. If the Dow closes positive on Tuesday it will be the 20th consecutive week. Market makers like to game these stupid oddities so assuming Europe, Asia or the Middle East does not meltdown over the weekend they will probably try to close the Dow in positive territory.

Resistance from Friday would be 1,650 followed by Thursday's high at 1,655. If the S&P can rebound over 1,655 and hold it then the dip buyers would probably return in volume.

S&P Chart

The Dow chart has not changed in several weeks. I warned for the last two weeks the uptrend resistance would be difficult and the Dow did make a concerted effort to break through like we saw on the S&P above. It was simply not able to do it despite a strong spike on Wednesday. The +155 point intraday gain on Wednesday was squashed and resistance held. That resistance for next week is about 15,500 and a suitable round number for traders to target. Strong support is 15,000-15,050. However, initial support formed at 15,200 over the last two days so that is the line in the sand to watch for a breakdown. Short term resistance is 15,325 and Thursday's high. Watch for lower highs and lows or higher highs and lows. That sounds simplistic but the Dow traded in a narrower range on Friday so the next move will be a strong directional clue.

The Dow closed positive on Friday thanks to AXP +$1 and PG +$3.18. Procter & Gamble replaced their CEO with a prior CEO and the market celebrated. Other than that the individual gains and losses were minimal.

Dow Stocks

Dow Chart

The Nasdaq blasted through resistance at 3500 on Wednesday only to see the spike hammered back to a strong loss. The resistance held. Even more interesting the drop on Thursday declined to exactly the level of the previously plotted uptrend resistance, which has now become support. I have been using this chart for the last two weeks and I have not moved that red line. This was a textbook dip to support on both days.

The RSI has dropped back into a more relaxed mode at 63 but the MACD is completing its downward cross. On paper this would seem to be the perfect setup for a breakdown but we have to get past Tuesday to be able to better predict it. There are too many macro factors involved with the holiday and month end that could impact the technical picture.

Initial support is 3425 and resistance 3465.

Nasdaq Chart

I love the Russell chart. I pointed out last week how the 1,000 level was going to be strong round number resistance. The index fought that battle for three days. When it did punch through intraday on Wednesday the spike immediately hit the blue uptrend resistance line and failed. Like the Nasdaq this is a textbook chart.

Resistance is 985 then 1,000. Support is 970.

Russell 2000 Chart

The Dow Transports stalled at the new high from last Monday at 6568 and could go no further. I mentioned last week the rally was slowing as it approached that 6560 level. Now we are faced with a lower high and lower low on Friday and critical support at 6325. The Transports were the worst performing index on Friday and they tend to lead the Dow. This suggests trouble next week for the Dow.

Dow Transport Chart

When traders are looking for an excuse to take profits they will always find one. Sometimes it finds them. The confusion over which Fed member said what, when and what did they mean was joined by the contraction in China's manufacturing PMI and Japan's market crash. It was the perfect storm for the U.S. markets but despite the big plunge there was no real damage done. When the smoke cleared the S&P had only lost -1.2% or -20 points from Tuesday's close at 1669. Given the gains since the April dip this was all smoke and no fire.

For the S&P to have a meaningful dip of -3% from that 1669 close on Tuesday we would have to drop to 1618 and we closed at 1649 on Friday. A -5% dip goes to 1585. If I could order a dip on command I would ask for a dip to the 1585 level because that would be severe enough to trigger stops and convince those sideline fence sitters to join the party.

Fortunately or unfortunately depending on your viewpoint I can't order up a garden variety dip to 1585. I am stuck with the rest of the market participants in hoping the market declines for an entry point but at the same time hoping it doesn't so my other positions don't get killed. This is a fickle business. When we are in a bunch of long positions we don't want a dip and they normally occur anyway. When we want a dip we can go a month without more than a hiccup in the market. Fortunately, we learn at an early age in our investing career that patience pays and there will always be another dip and another rally. Impatience is costly.

Enter passively and exit aggressively!

Jim Brown

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