Markets rolled over after hovering at resistance for two days. Japan, China and U.S. economics were blamed but it was more than likely just a normal correction continuation.

Market Statistics

The overnight sell off was started by news out of Japan. Capital spending by Japanese companies fell -1.8% in Q2. This reflects a slowdown in demand because of the first sales tax increase in 17 years. Corporate revenue and profits also fell an estimated -3.2% as the economy continued to deteriorate. Preliminary GDP estimates for Q2 showed a contraction of -6.8%. The revised estimates are due out next week. Mizuho Securities is predicting a decline of -7.9%. The prior week a report showed consumer spending declined -5.9% year over year for July. All of this negative data is coming from a country that is in the middle of a massive QE program and debt is now 230% of GDP.

The central bank has been buying 8-12 trillion yen in Japanese bonds every month and they have nearly exhausted the market supply. That equates to an average of $83 billion in QE purchases every month. The Mizuho Research Institute said the QE purchases could continue until 2020 in an unimaginable accumulation of debt. I have said multiple times in the past, "Japan is a bug in search of a windshield" and that windshield could be here sooner rather than later.

Obviously, with the economic data showing an accelerating decline in the economy the concerns are increasing over an eventual disaster. Since Japan is the third largest economy in the world, the implications are clear. If Japan's economy collapses, it will be a global event. The Federal Reserve will need to factor in the new Japanese forecast before they hike rates.

The Japanese Nikkei declined -3.84% on Monday and odds are good it will see new lows in the days ahead.


As if the Japanese data was not bad enough China's manufacturing sector fell into contraction with the government Purchasing Managers Index (PMI) falling from 50.0 to 49.7 for August. Government numbers are seen as questionable and having the official number fall into contraction is an admission that conditions are worse than reported. In a private survey by Markit/Caixin that is seen as more reliable the PMI declined from 47.8 to 47.3. That is a 6.5 year low and it is accelerating to the downside. Analysts are expecting China's GDP to grow by 6.4% rather than the official government projection of 7.0%. Some analysts are actually expecting the "real" GDP to be closer to 5% growth.

When the China PMI numbers were released, it was just one more weight on the overnight futures. The Shanghai Composite Index declined only -1.23%, which was remarkable since the Chinese government said it was no longer going to support the market. The month long effort to buy securities as a form of market support cost China's regulatory agency more than $200 billion and the market continues to make new lows. The regulator said it would focus on bringing parties to justice that were working against the government. Translated that means short sellers and any institution that is not holding the required number of securities mandated by government demands over the last month. The government has instructed firms, funds, large investors, etc to buy securities over the last month in an effort to support the market. Those efforts failed.


When the U.S. economic reports began to flow, they were not much help. The ISM Manufacturing for August declined from 52.7 to 51.1 for the second consecutive drop. That is the lowest reading since June 2013. New orders declined from 56.5 to 51.7 and production fell from 56.0 to 53.6. However, backorders rose slightly from deep in contraction territory at 42.5 to 46.5. That is the third consecutive month in contraction and is a good projection of what the headline number will look like in the months ahead. A lack of backorders suggests a weak manufacturing cycle.

New export orders declined from 48.0 to 46.5 and the fourth consecutive monthly decline. The strong dollar is reducing sales and with the emerging market currencies in free fall, it should only get worse.

Ten of the 18 manufacturing industries reported growth but six were in contraction with two neutral. Customer inventories rose a whopping +9 points to 53 and high inventory levels suggest a slowdown in customer sales and a potential drop in future orders. If customer inventories are too high because of slow sales they will not reorder. Eighteen percent of respondents said inventories were now too high compared to only 10% in July.

I warned about this report last week after several of the regional surveys showed unexpected declines into contraction territory. This ISM report is national and shows the manufacturing sector as a whole is weakening.


The Intuit Small Business Employment Index declined -0.02% and the first decline since 2011. That percentage equals a loss of -5,000 jobs by small businesses. The recent high was 0.13 in May, which declined to 0.11 in June and 0.04 in July. Small business employment has now declined for three consecutive months.

The Texas Service Sector Outlook Survey for August declined from 7.9 in July to 2.1 and a three-month low. The revenue component dropped nearly 10 points from 19.1 to 9.3. Employment declined from 10.1 to 6.1 and hours worked declined from 5.3 to 2.3. The index of future business activity (optimism) declined from 20.6 to 9.1.

On Monday, the Texas Manufacturing Outlook Survey dipped farther into contraction from -4.6 in July to -15.8 in August. New orders declined from barely positive at +0.7 to well into contraction at -12.5.

Clearly the economic conditions in Texas are slowing just as we have seen in New York and other Fed regions. While Texas manufacturing is contracting, the service sector is not yet into contraction but rapidly approaching that level. This is more than likely the result of the slowdown in the energy sector.

The only positive report for the day came from the auto sector. Sales for August rose to a seasonally adjusted annual rate of 17.8 million units. That is the highest rate since July 2005. Sales of light trucks rose to 57% and a ten-year high. This is undoubtedly a result of the lower gasoline prices convincing consumers to upgrade their class of vehicle. The light truck category includes models like surburbans, SUVs, etc. Sales of imported vehicles rose from 3.5 to 3.9 million. Chrysler had the biggest individual gain from 2.0 to 2.2 million units. Chrysler light truck sales rose +10% but auto sales declined -16% over August 2014. Overall, dealers sold 5% fewer imported cars but 28% more imported trucks. Overall 2015 sales are expected to exceed 17.1 million and the best year since 2001.

Wednesday will be a big day for economics. The ADP Employment will be the key in the morning and a material deviation from the forecast for 205,000 new jobs could dramatically impact the markets. A weak number could add to fears about the slowing U.S. economy. A strong number would increase the chances for a September rate hike. While the ADP number is not the official number the Fed watches it is a predictor of what to expect from the Nonfarm Payroll report on Friday. It is a preview of things to come.

The Fed Beige Book on Wednesday afternoon is another trouble spot. If conditions n the 12 Fed regions deteriorated over the last month then a September rate hike is probably off the table. Conversely if conditions improved, which would be a shock given the weak manufacturing reports, it would increase the chances for a rate hike.


One of the big stories for this week came from the oil sector. Crude oil rebounded from the prior week low of $37.75 to $49.30 at Monday's close for a 30% gain. The motive power that continued last week's short squeeze was talk about potential talks. Putin and Venezuelan president Maduro were going to meet in China on Wednesday to talk about stabilizing oil prices. Both Russia and Venezuela are large producers that have suffered significantly from the drop in oil prices. Venezuela is begging OPEC to call an emergency meeting to cut production. Since Venezuela cannot meet its current production quotas because of economic problems in the country, they want everyone else to cut production so prices will rise. Venezuela has nothing to lose and everything to gain. China is a major oil consumer and has loaned Venezuela billions of dollars which is being repaid with oil.

Nothing will come from the talks by those three countries. China is benefitting from the low oil prices because they are a big importer. It is not in China's best interest to see prices return to higher levels. Russia needs every dollar it can generate and is not going to cut production regardless of whether there is a joint agreement with OPEC to do so. Russia will claim it has cut and continue to pump at full speed. Remember, Russia did not invade Ukraine. Those Russian soldiers were on vacation according to Putin.

Crude prices collapsed -$4.04 or -8% during the regular session and WTI has declined another -$1.31 in the afterhour's session. Energy equities imploded with the rest of the market on the drop in crude prices.


Wynn Resorts (WYNN) declined another -5% after news that gaming revenue in Macau declined -35% in August. That is the 15th consecutive monthly decline. Wynn gets 72% of its revenue from Macau. WYNN shares closed at a new five-year low.


Netflix (NFLX) was knocked for a -8% loss despite Bank of America raising the price target to $133. The company said it was not renewing the content agreement with Epix when the deal expired at the end of September. The deal with Epix was not exclusive and the same movies were also available on other services. Starting on October 1st all the Epix movies will be available on Hulu. Netflix said it was going to allocate the money previously spent on the Epix content to developing additional original content for Netflix subscribers. Also, starting in 2016 Netflix will have exclusive rights to all the Disney content including Pixar, LucasFilm and Marvel productions. Think of the legions of children that will be downloading Star Wars movies for years to come.

This looks like another buying opportunity for Netflix investors. A drop to $101 would be a bargain.


GoPro (GPRO) hit a five-month low at $42.09 with a -6% drop on no news. The market correction is crushing all the momentum stocks that led the market to its recent highs. China could be a problem for GoPro because they do expect to sell a lot of cameras into that market. However, their manufacturing operations benefit from the cheaper yuan. It is hard to tell if the decline is over since the $38-$40 level was support in March. The low today was $42 and that could be a buy point for those traders that want to be early. I would buy it tomorrow with a stop loss at just under $38.


Ambarella (AMBA) reported earnings after the bell. The company reported earnings that rose +138% to 88 cents and beat estimates of 80 cents. Revenue rose +89% to $84.2 million. Analysts were expecting $81.7 million. However, the company guided for the current quarter to revenue of $90-$93 million, up +39% at the middle of that range. That was just short of analyst estimates for $92.3 million. The company said wearable camera revenue in Q3 would be down slightly because GoPro released their new model earlier than normal and pulled sales into the prior quarter. Historically that bump has come in Q3.

Last week there were rumors that Qualcomm (QCOM) may be considering entering the camera chip market and shares of AMBA declined sharply. Analysts said investors overreacted because neither Sony or Qualcomm could compete with Ambarella technology. Shares of AMBA declined to $81 in afterhours. I would look for a bottom to form in AMBA and I would be a buyer around $75.


The Biotech sector was a major drag on the Nasdaq the last two days after it failed at the resistance of the 200-day average. Biotechs have had a rocky period since the July high. Despite several mergers and attempted mergers it looks like investors are less excited than they were over the last year when the sector gained +83% from April 2014 through March 2015. I am sure the glory days will return but there needs to be some consolidation at this lower level in order to build a base.


Markets

Today's decline was textbook perfect for a rebound failure at resistance. Monday's lackluster session with a -115 point Dow decline was the actual failure. Today was a continuation that was accelerated because of the China/Japan headlines.

In theory, the rebound from the prior week's lows should have happened regardless of the headlines. We went from very oversold into a short squeeze relief rally and once that momentum faded we should have rolled over to begin the retest of the lows.

That is the typical pattern for an August/September correction. The process should take weeks to complete. However, the first two weeks of September normally have a positive bias. That could be erased by the pending FOMC meeting.

We always need to remember that historical trends are interesting to compare but they are never a guarantee. We need to trade what we see rather than what we expect to see. If the two happen to match then we should be happy campers.

Art Cashin has been warning for several weeks that cash on hand at mutual fund companies is at historic lows. That means a lot of redemptions will require the funds to sell stocks rather than redeem out of the cash balance. Art said if the decline today caused a lot of fund holders to put in redemption requests it will turn into market on close sell orders for Wednesday.

I would expect a lot of investors were shell shocked by last week's events. When the rebound occurred, they were calmed to some extent. When this week started out negative and then accelerated to the downside, it may have prompted quite a few to put in their redemption requests. Tomorrow afternoon we will see the results if that actually happened.

The S&P fell -58 points to close at 1,914 after hitting an intraday low of 1,903. The 1,920 level was seen as a potential support point and it held for a couple hours but finally collapsed near the close. Resistance is now around 1,928 and 1,940.

The lows from last week were 1,867 on Monday and Tuesday. We do not have to actually hit that low for a retest. Any decline and rebound from the 1,885 to 1,900 range would qualify and there may be some aggressive traders already placing their long bets in that range.

Tonight I am expecting a rebound at the open, assuming we are not hit by another round of negative headlines and that includes the ADP Employment report at 8:30. What happens after that opening rebound is going to be critical. I am sure the shorts loaded up again on today's decline and we could see another squeeze if there are no headlines to spoil the day.


All 30 Dow components were negative and most of the losses were big. The Dow was down nearly -550 points at 3:40 and was rescued by some market on close buy orders. The low was 15,979 or just slightly under 16,000. That 16,000 level should be decent support even though it was pierced last week. The high intensity plunge on Monday declined to 15,370 so we are nowhere near those lows. However, the closing low was 15,666 on Tuesday and that would be a support point.

There is nothing to prevent the Dow from continuing its decline. Half of the Dow stocks are in a bear market and most of the rest are down more than -10%. Until the individual stocks find their own support levels, the Dow should remain the weakest index. The Dow stocks are international companies and they have the most exposure to global economic weakness.

I would look for 15,780 to come back into play as minor support if the 16,000 level breaks.



The Nasdaq was crippled by some huge losses in the big cap momentum stocks. Google, Amazon, Netflix, Priceline, etc. The index lost -140 points and finished very close to its lows. There were no headlines specifically targeting tech stocks. There were simply more sellers than buyers and the momentum stocks were the ones getting sold.

Support is 4600, 4545 and 4500. Resistance would be the morning highs at 4715.



The small cap Russell 2000 had been the best performing index until today. The -2.7% decline was right in line with the big cap declines and there was no last minute buying in the small caps. They sold off from the open right through the close.

The decline back below 1150 is a sell signal and support may not appear until 1105 followed by 1050.


S&P futures are up slightly as I write this commentary and suggest a positive open. However, there is a lot of darkness before the dawn and anything can happen. Even if we do have a positive open we have seen market gains erased in minutes over the last two weeks. Because of the big decline today, I would expect some additional margin selling on Wednesday and we could have mutual fund selling at the close.

This rebound and fade scenario suggests we could retest the lows at some point in the weeks ahead. While that is not mandatory, it is typical for this calendar period. Remember to trade what you see rather than what you expect to see.

Investors with retirement accounts saw their net worth cut in half in the financial crisis. Then they were shocked again by the flash crash. Now the headlines are screaming global recession. I would not be surprised if a lot of potential retirees are calling in their sell orders to go to cash rather than face a potential 50% haircut once again. Be prepared for continued volatility in both directions.


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Enter passively, exit aggressively!

Jim Brown

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