What we saw last week was a classic example of market distribution at a perceived top.

Weekly Statistics

Friday Statistics

Distribution is where large investors, portfolio managers and trading programs try to calmly exit the market just before a perceived top by slowly selling their positions to those who still believe the market will move higher. Rather than just put in a sell order for all of their positions, which could immediately crash the market, they liquidate their positions in bite-sized chunks a little at a time, whenever the market appears to be gaining momentum. By selling into the intraday rally, they capitalize on the buying volume to avoid depressing prices. This can go on for several days or a couple weeks depending on the market and the calendar. On Friday, they had an extra bit of help with the quadruple expiration and some rebalancing issues which increased volume significantly. If you want to hide your actions, it is best to do it in a crowded market.


Volume last week was very strong despite the lack of upward progress. This is another sign of distribution. Back before the election, the average volume was about 5.6 to 6.2 billion shares a day. The two days after the election that spiked to more than 12.1 billion shares on the 9th/10th of November before drifting back down to about 6.5 billion a day the week before Thanksgiving. Rising volume in a declining market is a bad sign and the Dow and the Nasdaq 100 were the only major indexes posting a gain for the week. Also, note the decline in the stocks making new 52-week highs.

Next week, volume on Monday should be heavy as option settlements provide some additional activity. Beginning on Tuesday volume will begin to slow drastically as the week progresses. With Christmas on Sunday, the market will be closed on Monday so this is a full week of trading.


The economic news for Friday was negative with new residential construction starts falling from a rate of 1.323 million to 1.090 million. That was an 18.7% decline. The consensus estimate was for a minor decline to 1.222 million. Single-family starts fell from 863,000 to 828,000 and multifamily starts fell -45.1% from 477,000 to 262,000.

Housing permits, a key indicator of future starts, fell from 1.260 million to 1.201 million. Single-family permits rose slightly from 774,000 to 778,000. Multifamily permits fell from 486,000 to 423,000.

On the positive side, completions rose 15.4% to 1.216 million units in November. This suggests builders accelerated their already started homes in order to complete them before the harsh winter weather arrived. With mortgage rates rising, the pace of sales and building should moderate.


The economic calendar for next week is very bland with the third revision of the Q3 GDP the only highlight. The GDP is not expected to change materially. The personal income and spending on Thursday will be of interest to the Fed but traders will not be around to see it.

Janet Yellen speaks on Monday and she is the only Fed speaker for the week.


One factor weighing on the market on Friday was a series of implied earnings warnings. Honeywell (HON) said Q4 earnings would be at the low end of their forecast range. The company guided to earnings of $1.74 per share compared to prior guidance of $1.74-$1.78. For 2017, they guided to earnings of $6.85-$7.10 and analysts were already expecting $7.08. The COO said they expect organic sales growth of 1% to 3%, margin expansion of 70-110 basis points and EPS growth of 6% to 10%. Despite the lowered guidance, everything else the company had to say was positive. Shares collapsed $3 on the news but recovered to close fractionally positive for the day.


The Honeywell news came on the heels of United Technology's lower than expected forecast on Wednesday. The company guided for adjusted earnings of $6.30-$6.60 for 2017 and analysts were already expecting $6.59. They actually admitted some of the earnings gain for 2017 was due to their buyback program reducing the number of outstanding shares. Rarely do companies actually admit that even though everyone understands the math. The company said they were confident they would see 2% to 9% sales growth in 2017 as a result of their many acquisitions. Revenue is expected to be $57.5 to $59 billion and that compares to $57-$58 billion in 2016.


On Wednesday, Caterpillar (CAT) said they were maintaining the quarterly dividend at 77 cents payable February 18th to holders on January 20th. However, they also cautioned that current earnings estimates were overly optimistic. They are in the midst of a dramatic change in their business and the business conditions. They said the energy sector had not recovered and overseas sales had not improved significantly. Earnings in 2014 were $6.38 per share, 2015 $4.64, 2016 is estimated to be $3.26 and 2017 is estimated at $3.15. Caterpillar said those estimates were overly optimistic. Shares had a bad week and closed at three-week lows.


The weak earnings guidance from three major industrial companies came after the Wall Street Journal ran an article on Thursday saying "the stock rally is more hope than substance." The article said, "When markets move a long way very fast, they become vulnerable." Momentum builds and builds and when investors finally jump off the roller coaster at the peak, the decline can be ugly. They were not saying anything we do not already know.

Merrill Lynch said fund managers rotated into industrials far too quickly and the actually results of the new president's changes will not be felt for a long time. The article warned of the sudden wakeup call when Trumps rhetoric meets congressional reality about midyear.

On the back of that headline, we had three major industrial stocks tell us that sentiment was too bullish for this point in the cycle. That is damaging to the momentum buying that has lifted the market to these levels. The impact on Friday was minimal but the irrational exuberance bell has already been rung.

JP Morgan downgraded Nordstrom (JWN) from neutral to sell following a meeting with management. JPM said the company had relatively flat sales and no "silver bullets" on the horizon to improve trends. Nordstrom management told analysts that traffic to brick and mortar stores were the worst since 1972 as more shoppers move online. JPM said "service and experience is the key foundation of the Nordstrom model, accelerating channel shift to the lower conversion online channel with no sightline to equilibrium, has structurally altered the company's multi-year top and bottom-line profile." Translation, brick and mortar retailers are being crushed by Amazon and other online sellers. Shares fell 9% on the news.


Gilead Sciences (GILD) got some bad news when a court ordered it to pay $2.54 billion to Merck in an ongoing legal battle on hepatitis C drug patents for Sovaldi and Harvoni. The court ruled that Gilead infringed on an Idenix Pharmaceutical patent covering methods used to develop the drugs in question. Merck acquired Idenix in June 2014 for $3.9 billion. Gilead will have to pay 9% royalties on future sales. That award is the largest patent dispute payout ever. A Gilead spokeswoman said the company "respectfully disagrees with the jury's verdict and damage award and intends to vigorously challenge the outcome through the appeal process." Gilead had $31 billion in cash at the end of the quarter. Shares fell -2% on the news.


Dow Chemical (DOW) announced the conversion of $4 billion of its Series A Convertible Preferred Stock into common stock. Each share of preferred will be converted into 24.1 shares of common stock. Why is this material? Dow has been paying $340 million a year in preferred dividends to Warren Buffett and Kuwait's sovereign wealth fund. Berkshire Hathaway was receiving $255 million a year and Kuwait $85 million. Those entities bought the preferred shares back during the financial crisis when Dow desperately needed the money. Shares declined because that means an additional 96.8 million outstanding shares of common stock.


Apple (AAPL) shares were flat for the last three days and the earnings from Jabil Circuit (JBL) did not help. The company posted earnings of 69 cents compared to estimates for 64 cents. However, analysts were looking for sales numbers since Apple accounts for 24% of Jabil's business. Revenue declined -2% and that was significantly better than the 12% decline analysts were expecting. Jabil said handset product volumes were softer than expected but would pick up in the latter half of 2017. That is when the iPhone 8 will begin manufacture. JBL shares rallied 12% on the better than expected revenue and that news kept Apple shares from declining in a weak market.



Chipotle Mexican Grill (CMG) reached a settlement with Bill Ackman and Pershing Square Capital. In September, Ackman announced a 9.9% stake in CMG. Now, after three months, CMG added four new directors to the board. Two of them were chosen by Ackman and two by CMG. One of Ackman's picks was Matthew Paull, former CFO for McDonalds. In exchange for the two directors, Ackman agreed to remain silent publicly for two years and refrain from increasing his stake to more than 12.9%. Ackman said the CMG board had always been blamed for being too close to management and the board needed a shakeup. Shares rallied $10 on the news.


Jefferies recommended UnitedHealth as its top pick in the managed healthcare sector ahead of the repeal of Obamacare. Jefferies said UNH had contracts with 850,000 doctors and more than 6,000 hospitals. Their broad spectrum of offerings, outstanding earnings and reduced exposure to the public exchanges made them the outstanding pick. Jefferies said even at current levels UNH is still undervalued to the market and it is the safest call amid the healthcare uncertainty. Shares broke out to a new high and helped keep the Dow from going deeper into negative territory.


Crude prices remain stuck in the $50-$52 range as we wait for the OPEC headlines to fade and the January production numbers showing a negligible decline in total production. U.S. production jumped 100,000 bpd last week to 8.796 mbpd. That is the highest level since June. Higher prices will continue to increase production in the USA.


Active rigs rose by 13 to 637 after a jump of 27 the prior week. Oil rigs increased by 12 and gas rigs by 1. This is the highest level of active rigs since January 22nd but still just one third of the 1,931 rigs that were active in September 2014.


 


 

Markets

The current post election rally is the largest one on record for 28 days after the election. The S&P was up 8.7% at Tuesday's close and the Dow was up 11.3%. In modern history, there were only five rallies of 5% or more post election. Of those, four went on to gain another 10% over the next six months.

History does not always repeat but it would be nice if it did in 2017. As one analyst put it, "starting in January there is going to be a tectonic shift in asset allocation." Stocks that have worked over the last 8 years are going to be kicked to the curb in favor of stocks expected to work over the next four years.

Other analysts believe the shift has already occurred and those favored for the next four years have already reached the top of their gains.

I am in the middle. Some stocks are grossly overbought. However, most portfolio managers are not going to completely restructure their portfolios in the six weeks before year-end. There are too many variables including peer performance, bonuses and tax planning just to name a few. Most managers will wait for January and the start of a new year for performance measurement and taxes before making wholesale changes. Did they buy some of the hot stocks over the last five weeks? Absolutely but they will buy more once the calendar turns over and they can liquidate existing positions.

I do believe we will see significantly higher highs in 2017 but probably not in January. If you remember January 2016, it would be hard to tiptoe blissfully ignorant into 2017. There was no warning and the selling started on December 30th. The Dow fell -14.7% at -2,270 points to hit a low of 15,540 on January 20th. The Nasdaq fell from 5,107 to 4,209 or -21.3%. The Russell 2000 fell from 1,160 to 943 or 23.0%. Given the gains in recent weeks, we could repeat that decline.

Dow - January 2016

However, given the stock rotation scenario, I do not expect any decline to be that violent. While we could easily decline 5% to 7%, the rotation into other stocks could prevent a complete washout.

NOBODY can accurately predict the market's future. However, there is a preponderance of evidence that suggests the first couple weeks of January could be rocky.

The Dow is clearly in distribution with solid resistance at 19,950 and big intraday declines. Thursday the Dow closed 100 points below the intraday high and Friday was an 80-point decline intraday. Short-term support has formed at 17,760 giving us about a 200-point range to watch for a breakout or a breakdown.

The four consecutive intraday failures over 19,900 have reduced the importance of Dow 20,000. I wrote over the last two weeks that sellers were probably going to begin selling just under Dow 20K in order to beat the rush and maintain that 20K target for those still investing in the rally. That has now happened for four consecutive days. That reduced a lot of the stock available to sell and should have made a touch of 20K a less reactive event.



The S&P has found some short-term support at 2,250 but it has also put in three consecutive lower highs that suggest that support will fail. The rotation from sector to sector has helped support the S&P because rising sectors are offsetting declining sectors.


The Nasdaq Composite is trapped in a narrow 50-point range between 5,430 and 5,480. The Friday close was just above that lower support and suggests further weakness ahead. A decline below prior resistance at 5,400 could see a drop to 5,200.

The big cap tech stocks cannot seem to post consecutive gains. One day they are up and then next they are declining. This is sector rotation. Some portfolio managers are taking the opportunity to lighten up on the techs when they get a good bounce to offset their selling.



The Russell 2000 Index closed with a -2 point loss but that was -15 points below the intraday high. The Russell was the largest gainer in the rally at +20.1% and that suggests it could be the biggest loser in any future decline.


I expect the market to be choppy this week but maintain a positive bias. Fund managers will be trying to keep their window dressing in place to exit the year on a high note. However, the closer we get to the end of December the more likely the selling pressure will increase.

I am looking forward to a major buying opportunity in January in hopes of establishing some long-term positions. I sincerely hope readers are ready for a potential dip. If it does not appear, the short covering and price chasing could be enormous because quite a few investors and analysts are expecting that buying opportunity.

I would refrain from being overly long and I would definitely keep my stop losses in place.

 



 

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Random Thoughts


A big chunk of investors jumped back to the bearish camp but a few became more bullish. The neutral camp is losing followers at a rapid rate. Neutral sentiment was at 42% before the election. At 23.0%, that is the lowest reading since November 13th 2014. This survey ended on Wednesday.

Last week results


The real election is Monday. The Electoral College will meet on Monday in their respective state capitals to cast the official votes for president. Twenty-nine states bind their delegates and they have to vote for whoever won the popular vote in the general election. One elector has resigned rather than vote for Trump. Three others in Colorado have sued to be released from their bindings so they can vote for Trump instead of Clinton.

There are 538 electoral votes to be cast. The 12th amendment requires 270 votes for the president to be elected with a majority. The votes will not be counted until January 6th, during a joint session of Congress and only then will the winner be announced. As president of the Senate, Joe Biden will preside over the joint session and announce the results.

Trump won 306 electoral votes in the general election. Republican officials have been in touch with all 306 and they believe only a "few" may vote for somebody other than Trump. A total of 68 electors from 17 states have asked James Clapper, the Director of National Intelligence, for a briefing on why the U.S. believes Russia was behind cyberattacks intended to influence the election. Clapper has refused saying he will not give any briefings until after President Obama's official review is completed in January.

It would require 37 "faithless electors" to withhold their votes from Trump to prevent him from being declared the winner. The election would then go to the house where the president would be chosen. Since the republicans hold a majority in the house, it is assumed they would choose Trump.

Obviously, this normally mundane Electoral College process could cause a real problem for the market and the economy if there are enough faithless electors to prevent Trump from getting the 270 votes. I do not want to even consider the potential impact to the market and to consumer sentiment. This would produce unimaginable market volatility.


Steven Gail began writing for Option Investor in March 2003. In the last 13 years, he has filled many roles and always did a great job. Steve was a finance teacher at UCLA, a singer and musician. He performed for thousands every year and was a hit everywhere he went. For the last several years, Steven has been fighting leukemia and he finally lost the battle last week. If I wrote another 1,000 words, I could not tell you what a great, funny, honest, sincere, hard working person Steven was. Reading the comments on his Facebook page show that he was equally admired by everyone he knew.

I know a lot of readers still kept in touch with Steven and he will be missed terribly.

Karaoke night. 6 months ago. Mac the Knife
Jamming with friends. December 10th. Steven being Steven



 

Enter passively and exit aggressively!

Jim Brown

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Grants Interest Rate Observer