The August curse is alive and well with the market declining the most in since mid June.
The Dow lost -233 points for the week to close just above critical support at 15,400 as the Q2 earnings cycle fades and worries over QE tapering rise. Last week was the normal week in August for the seasonal decline to begin. Next week is expiration week and I would expect the weakness to continue the week after. Historically traders should beware August expiration week. Five out of the last eight years the markets have declined over the next two weeks.
If you were not a JC Penny's (JCP) shareholder there was not a lot happening on Friday. It was just another low-volume day with all the market action coming before noon when traders closed up shop and left for the weekend. The Dow declined -152 to 15,346 at the morning low but cut those losses in half as shorts took profits and a few dip buyers hunted for bargains.
The two economic reports were ignored. Wholesale inventories for June declined -0.2% after a -0.6% decline in May. This was the third consecutive month of declines. Analysts were expecting a gain of +0.3%. There are two possibilities here. First, purchasing managers may have been anticipating a decline in economic activity and sales and let inventories decline on purpose. The second possibility was that sales were stronger than expected and the decline caught managers off guard. In the first possibility they would probably not be planning on placing orders to build it back up but in the second option they would place replenishment orders. The problem is that we don't know which reason for the decline was correct.
The Weekly Leading Index rose microscopically by +0.1 to 131.8 but that was the highest level in more than two-years. This suggests growth will continue to rise but at a very slow pace.
The economic calendar for last week was devoid of any material events other than Fedspeak. This week has something almost every day with the Philly Fed Survey on Thursday the most important report for the week. The Retail Sales on Tuesday is probably tied with the two housing reports for the second most important.
The weekly jobless claims are not highlighted but they have been declining for the last two months with the prior week's claims at 328,000 and the lowest level since the recession. Summer claims are normally erratic because of automobile factory shutdowns for retooling. Also claims tend to decline in late summer as people put off looking for work until the kids go back to school. If claims continue to decline this would be very bullish for the economy but I don't know anyone that expects that to happen.
We saw some additional data from China and Europe that suggests the global economic weakness may be fading. China reported stronger than expected exports that rose +5.1% in July compared to estimates for a +3% rise. This compares to the -3.1% decline in June. Imports jumped +10.9% compared to expectations for a +2.1% rise and a decline of -0.7%. China's PMI manufacturing and services numbers both came in unexpectedly higher as well. We don't know if all these numbers are "manufactured" by the government to overcome the negative publicity in July but they are what they are. The majority of investors will take them at face value and move forward.
Economics in Europe continue to improve with Germany leading the recovery.
Japan is the black hole in Asia with economic improvement still an elusive goal. The country is testing the upper limits of computing equipment. On Friday Japan's debt exceeded 1,008.6 trillion yen or 1 quadrillion yen. That makes it the first major economy to experience a quadrillion and the debt is still growing. The debt increased +1.7% in Q2 and now exceeds more than 200% of GDP. How big is a quadrillion? That is a 1 followed by 15 zeros or 1,000,000,000,000,000. That is a lot of money and actually a lot of anything. As a computer programmer just out of college in the late 1960s I had to allow for the size of the largest number in any calculation and when setting up report formats. You can imagine the challenge for Japanese programmers trying to handle numbers that big. Of course the economists have a bigger problem in trying to make them go away.
Analysts believe Prime Minister Shinzo Abe will be forced to implement a large sales tax increase to keep the debt from increasing further. The plan is to raise the national sales tax from 5% to 8% in April and then to 10% in 2015. Moody's said Japan was nearing a tipping point where creditworthiness could destabilize the Japanese financial system. "Without sustainable economic growth the government's willingness to expand its deficit and attempt to inflate the economy into a recovery will be of limited effect." Interest rates will rise sharply and with that much debt it would be impossible to pay higher rates and the country would collapse.
I have written about the impossibility of the Japanese situation several times before. The scale of the numbers is already out of the bounds of possibilities. It is only a matter of time before Japan implodes. As John Mauldin is so fond of saying, "Japan is a bug in search of a windshield."
A Pennsylvania man has Japan beat. Last month PayPal mistakenly credited his account with $92,233,720,368,547,800 dollars. He said that was quite a surprise and a little more than he was expecting. If he had been fast enough he could have paid off the $17 trillion in U.S. debt and still had more than $92 quadrillion left. His second goal was to buy the Philadelphia Phillies, "If I could get a good price." For a couple hours he was the world's richest man then he logged back in to show someone and his account had been reset to zero. PayPal apologized for the error and offered to make a donation in his name to the charity of his choice.
The improving economics are putting more attention on the potential for tapering QE. The entire premise for QE is to energize a flat and lackluster economy. In our case the recovery in the U.S. has been slowed by the two-year recession in Europe and the nine-quarter slowdown in China. If those economies are improving that implies the U.S. economy will improve and therefore an end to QE and the beginning of higher interest rates.
Obviously that is a real stretch between theory and actually seeing the U.S. economy improve but the headlines are supporting our market. The positive economics overseas knocked the dollar to eight-week lows. That should have helped push commodities and equities higher.
Dollar Index Chart
Crude prices rose from Thursday's $102 low but it was more headline related rather than falling dollar. The International Energy Agency (IEA) released its monthly update on demand and production and they conflicted somewhat with the same monthly release from the U.S. Energy Information Agency (EIA) and OPEC.
The EIA boosted its estimate of global demand by +200,000 bpd to 1.1 mbpd in 2013 to 89.99 mbpd. They also expect demand growth in 2014 of 1.2 mbpd to push demand to 91.21 mbpd.
OPEC also released their monthly update claiming 2013 demand growth would be +800,000 bpd with another 1.04 mbpd growth in 2014. They expect total daily demand in 2013 to be 89.7 mbpd rising to 90.75 mbpd in 2014.
The IEA cut its demand growth forecast for 2013 from +930,000 bpd to +900,000 bpd. They lowered the 2014 growth forecast from 1.2 mbpd to 1.1 mbpd with total demand at 90.8 mbpd in 2013 and 91.9 mbpd in 2014.
The EIA expects U.S. production to rise +100,000 bpd in the rest 2013 to average 7.4 mbpd. However, production hit an 18-year high at 7.56 mbpd last week and still rising. We started the year right at 7.0 mbpd so we have already seen gains of +560,000 bpd and odds are very good we will be a lot higher by year end. Production has been rising by about 10-15,000 bpd per week with 20 weeks left in the year. They expect an average of 8.2 mbpd in 2014.
Global production is expected to increase +1.4 mbpd in 2014 led by the U.S., Canada and Brazil. Production will keep pace with demand growth for the next couple years as long as everything runs smoothly at all the new projects and the global economy does not accelerate unexpectedly.
The takeaway here is that all the major agencies are looking for something in the 90.0 mbpd range for demand at year-end and 91.0 by the end of 2014. The IEA is expecting a faster improvement in the global economy. Currently supply is growing slightly faster than demand so prices should moderate once we get past the summer driving season and the security issues overseas.
OPEC production declined -165,000 bpd in July to 30.41 mbpd and the lowest in six months. This was due to disruptions in Libya and Iraq. Nigeria is still struggling to maintain output, Sudan is preparing to shutdown pipelines as the result of border disputes and Iran is going to be sanctioned even harder once U.S. lawmakers come back from the summer recess. Saudi Arabia increased production by +150,000 bpd in July to 9.8 mbpd and a 12 month high to compensate for falling production elsewhere in OPEC. The cartel is still producing about 400,000 bpd more than the IEA demand forecast for OPEC oil in Q3. This should also pressure prices if some of the other production outages are cured.
Crude prices spiked on the economic numbers from China and news of disruptions in the Middle East. WTI rose +$2.63 to $106. This was likely due to some short covering as well because nobody wanted to be short crude over the weekend with Middle East violence increasing.
An Israeli drone strike in Egypt killed five suspected militants and destroyed a rocket launcher in the Sinai Peninsula. Just three of those words should strike fear into anyone that was short crude. "Israeli, drone and Egypt" suggests the possibility for things to go horribly wrong without a strong government in Egypt.
Coasta Cruises announced the cancellation of all Egyptian port calls for the rest of the 2013 and 2014 seasons. With the travel warning for nearly all of the Middle East and Northern Africa the cruise companies are going to be fighting a losing battle.
The U.S. will reopen 18 embassies on Sunday. The embassy in Yemen will remain closed. The consulate in Lahore, Pakistan will also remain closed due to a "separate credible threat." U.S. citizens were warned to stay away from Pakistan and U.S. nationals were told to leave Yemen immediately. Five U.S. drone strikes in Yemen killed 22 suspected Al Qaeda related militants over the last week.
WTI Crude Oil Chart
Earnings news was fairly light on Friday as the Q2 cycle winds down. Monster Beverage (MNST) was up slightly after reporting earnings of 62 cents compared to estimates of 64 cents. Revenue of $630.9 million also missed estimates of $650 million. Shares were up on positive comments about new products taking market share.
Rackspace Hosting (RAX) reported earnings of 16 cents compared to estimates of 13 cents. Revenue rose +18% to $375.8 million that beat estimates for $372.2 million. The number of servers in its facilities rose +16% to 98,884. Revenue per server rose to $1,298 per month. That is extremely high per server revenue. I recently paid about that for an entire rack of 12 servers at a Denver data center. RAX shares rose +8% to $48.
Allscripts Healthcare (MDRX) reported earnings of 5 cents compared to estimates for 10 cents. Revenue fell -7% to $345 million with a backlog of $3.2 billion. Shares declined -4% to $15.50.
Priceline reported earnings of $9.70 Thursday night compared to estimates of $9.38. Bookings rose from $7.83 billion to $10.1 billion. Raymond James raised the price target on PCLN shares to $1,100 from $1,050. Evercore Partners also has a $1,100 target on the stock. Credit Suisse analyst Stephen Ju raised his target from $924 to $1,200 saying the company remains an "open ended growth story." Shares of PCLN hit $994.98 intraday but fell back to close at $970 on profit taking. That was still a $36 gain for the day.
JC Penny (JCP) was the talk of the day after hedge fund manager Bill Ackman demanded the ouster of the Chairman and the interim CEO. Ackman sent an open letter to the Penny board, his second in two days, publicly criticizing the board and demanding the ouster of Chairman Thomas Engibous. Engibous was chairman of Texas Instruments and CEO of TXN from 1996-2004. He has been on the JCP board since 1999.
The day before Ackman demanded the immediate replacement of CEO Myron Ullman.
In Friday's letter he said "I have lost confidence in the chairman's ability to oversee the board." He claimed Penny was at a critical stage and the board had ceased to function effectively. On Friday he was joined by hedge fund Perry Capital, which owns 7.3% of JCP. Together Ackman and Perry capital own almost 25% of JCP.
The board fired back saying Ackman's statements were "misleading, inaccurate and counterproductive." The charges and counter charges made headlines all day.
Starbucks CEO Howard Schultz injected himself into the battle saying Ackman should be removed from the board for his public demands that were damaging to JCP. Schultz pointed out that Ackman was responsible for installing Ron Johnson as the failed CEO that undertook a complete overhaul of the JCP retailing model and drove Penny nearly into bankruptcy. Now he wants to do it again by having his new picks for Chairman and CEO installed so he can finish the job. Ullman is on the board of Starbucks and Schultz has known him for a long time.
BlackBerry (BBRY) spiked +6% on comments the company is "open" to going private. Considering the market cap for BBRY has fallen from $84 billion to $5 billion that could be seen as cheap. The company had cash flow of $630 million last quarter and has no debt. They have about $3 per share in cash, $2 in short-term investments and $5 per share in receivables. That totals $10 and shares closed at $9.77. If you could buy it at that price the rest of the business would be free. Obviously you can't buy it for $5 billion because they still have an ongoing business and a large enterprise servicing business that is said to be worth $2-$3 billion on its own.
There are new products headed for sale and the Z30 pictures and partial specs have been leaked and it looks like a really nice device. It is rumored to have a dual-core 1.7 Ghz processor, 8MP camera, 5 inch screen and 2800 mAh long life battery. BlackBerry users are already drooling over the pictures. The company has a lot of problems but nothing new management could not fix. Microsoft has been speculated as a buyer. Lenovo has mentioned more than once they would be interested. The private equity guys would be all over it if they knew for sure the new products were going to catch fire.
I would not expect BBRY to just keep going up on these rumors but I do believe they are acquisition bait. There is too much history and infrastructure there to just let them die or wander around on their own with random product launches. They need an aggressive management team and they could begin regaining market share with some competitive devices.
You may see pigs fly before all of this happens but strange things do appear from time to time. Who would have thought Michael Dell would want to buy back all the headaches of a shrinking computer market for $15 billion? There is always another idiot with a lot of money that believes he can make more. I suspect none of our readers would be jumping back into the fire if they had $15 billion in the bank.
With all the Fed taper talk the investor interest in buying treasuries is fading. Without the Fed's $45 billion in treasury purchases every month there will suddenly be a surplus in the market and that is going to push yields a lot higher.
The lack of buying interest is showing up in the bid-to-cover (BTC) ratios in recent auctions. The BTC for last week's 30-year auction fell to 2.11. That means there was $2.11 in bids for every $1 being auctioned. That was the lowest BTC since February 2009 except for the drop on August 11th, 2011 when the last debt ceiling battle was underway in Washington.
Debt ceiling headlines already beginning but as we all know nothing will be resolved until the last minute and that is October 1st.
If bids are already low how much lower will they be when the Fed is no longer a buyer? The Fed owns 20% of all outstanding treasuries.
The chart below is the 6-month moving average of the BTC not the actual weekly numbers. The green line on the top is the ten-year treasury.
Treasury BTC Chart
However, yields on the ten-year treasury declined to a two week low last week at 2.58% as the equity market sold off and treasuries were bought. Apparently investors are reconsidering the safety of treasuries in spite of the taper talk because of the risk for an equity market swoon over the next six weeks. You can bet we will see yields return to the highs as we near the September FOMC meeting.
Ten-Year Treasury Yield Chart
Beware expiration week in August. Five of the last 8 years have been down for expiration week and the week after. That is a recent trend rather than a guarantee but investors should pay attention. Actually September is normally worse for the markets but low volumes in August tend to produce the initial declines.
The decline last week was the third worst of the year for the Dow. It was the second worst week for the S&P and the Dow Transports. The homebuilders declined the most in 14 months thanks to rising mortgage rates.
Home Construction ETF Chart
The better news from Europe and China pushed silver to its third best weekly gain of the year and copper to the best gain in 11 months. Silver is outperforming gold and a push over $20.50 could trigger significant short covering and technical buying. It closed over the 50-day average on Friday.
Copper surged from the $3.03 low at the end of July to more than $3.30 at the close on Friday. That surpassed the 100-day average on copper and puts the metal on track to retest strong resistance at $3.40.
The trailing 12-month PE on S&P was 14.5 a year ago. That has risen to 17 today with earnings growing about 1% in Q2. Bull markets tend to end when the PE reaches 18.0-18.2. The current bull market is 1,600 days old. From 1928-1973 the average bull was 1,140 days. Since 1973 the average bull has been 2,650 days. If that average holds true the party is just getting started. I am definitely not predicting that, just reporting.
Monday was the lowest volume for a full day of trading in 12 months at 4.6 billion shares. The average for the week was 5.37 million. This is the summer doldrums and we should not expect any material volume increase without a major headline to disrupt the markets.
New 52-week highs declined to 286 on Friday from 1,006 on August 1st. New 52-week lows rose to average 245 on Tue/Wed, up from 85 on July 30th. Market breadth is shrinking.
Margin debt is at an all time high and net investible cash at a 20 year low. That suggests that many stocks are in the hands of weak holders and subject to be stopped out on margin calls with any material market volatility. This is a symptom of market tops. Investors become complacent and stretch their margin to try and capture the maximum profits. It also means there is less margin left to keep the rally going. When traders are margined out they have no more buying power and they have to eventually sell something to free up cash.
The S&P fell back below 1700 on Tuesday and then failed to rebound back over that level on Thursday. The gap up at Thursday's open touched that level but selling immediately appeared. Later in the afternoon another rebound attempt stalled at 1700 again and the market sold off into the close. On Friday the S&P rebounded to retest the 1700 level for about 5 minutes after an opening gap lower. Program trades hit at 10:AM and pushed it down to support just above 1685. The afternoon rebound was lackluster and selling began again at 1:30 with a 1691 final print. The futures continued lower after the close to end on exactly 1685.
Support remains 1680-1685 and that is a critical level. If we breakdown from there it could signal fund managers to begin taking profits to lock in gains and bonuses for the year. September is normally the month when portfolio shuffling begins but with the markets up +25% since November and a potentially ugly debt ceiling fight and QE tapering in September they may want to exit early.
Resistance remains 1700, 1710 and 1725.
The Dow's decline on Friday could be signaling trouble. Support at 15,500 has clearly broken and now 15,400 is being tested. The low for the day was 15,350 but it was brief and the dip was instantly bought. Afternoon resistance was 15,450 so we have a clear pattern of lower highs and lower lows. The intraday low was a four-week low. The Dow declined -152 points at the open and only recovered half of that by the close. Dip buyers are going to tire of the game very quickly without a meaningful bounce back into positive territory.
Dow Chart - 60 Min
Dow Chart - Daily
The Nasdaq chart has not really changed. The sharp gains at the end of last week saw limited profit taking and the Nasdaq closed at 3660 only -32 points from the closing high on August 5th. The tech sector seems to be passing time while the broader market decides a direction. The Nasdaq has support at 3640 and 3580 giving it plenty of room to run without breaking the recent uptrend.
The Russell 2000 is also holding the high ground rather well. Uptrend support was tested and held and the index only gave back -11 points for the week after closing at a historic high on Monday. Support is 1040-1045 and resistance 1060-1065.
Fund managers have shown no fear by selling small caps. As long as this pattern continues the broader rally should do fine. A break below 1040 would be the signal to head for the exits.
Russell 2000 Chart
Regardless of what happens next week we have to prepare ourselves for September. The instant lawmakers return from the August recess on September 9th the budget battle will begin. Both sides have already proclaimed a steadfast pledge not to cave in on their principles and assuming they stick to that pledge it will be very ugly. Talk of shutting down the government is already the topic on all the political news shows. Of course each side is already blaming the other for the shutdown. This posturing will continue to become more adamant until a solution is reached around October 1st. Nothing ever gets done until the last minute and government funding expires on Sept 30th.
The last time we had this battle was August 2011 and it was very detrimental to the equity markets. With the Fed taper announcement expected on September 18th the period between the 9th and 18th could be very volatile and assuming a taper is announced the rest of September could be a disaster with the budget battle still in progress.
S&P Chart - 2011
I can't help but think fund managers are seeing this scenario and will begin locking in profits in the near future. We need to be cautious with long positions and keep our stops tight because we never know when the market will trip over a headline and plunge into the abyss.
Enter passively and exit aggressively!
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