The market action last week and specifically the action on Friday set us up perfectly for additional gains next week.

Weekly Statistics

Friday Statistics

The setup is so good is scares me because there must be something I am overlooking or there is a black swan event fixing to bite us in the back. The Russell did not decline as expected on the rebalance and actually gained 10 points. Assuming the historical trend holds for a positive bias the week after the rebalance, the Russell should rise next week. The Dow made a new high on Monday and then retraced to fill the gap at 21,384 and despite a little volatility on Friday, it closed right above 21,390 and support all week. The Nasdaq fought resistance at 6,245 all week and then moved over that level on Friday with a decent gain. The FAANG stocks were all positive and Facebook closed at a new high. This suggests the quarter end window dressing will be focused on those stocks and should lift the Nasdaq higher. Next week is a pre holiday week and is typically bullish.

With all the positive points, the setup is too good to be true but I am sure most of us will be happy if it plays out as expected. The perma bears are going to be doubling down on their shorts on Monday as they do whenever I turn bullish. It is normally a bad omen for the market.


There was only one economic report on Friday but it was big news. The new home sales for May rose from the previously reported 569,000 to 610,000 and well over the Moody's estimate for 588,000. That was a 2.9% increase from April and 8.9% over May 2016. Over the same period, the median home price is up 16.8% to $349,400. April sales were also revised higher to 593,000.

The lack of inventory is leading to more homes being sold before they were completed. The percentage of homes sold where construction had not even started rose from 30.0% to 34.1%. Those sold while under construction declined slightly from 37.3% to 33.4%. Sales of completed homes fell from 44.5% to 32.5%. The inventory to sales ratio was flat at 5.3 months. The annualized rate of completions is roughly 800,000 but that is well below the 1.2 million in the 1995-2000 period.

On Wednesday existing home sales rose from 5.57 million annualized to 5.62 million. This report and the new home sales are positive for the GDP.

We will get the last revision of the Q1 GDP on Thursday and the consensus estimate is for unchanged at 1.2% growth. Moody's is expecting a drop to +0.8% growth.

The Q2 GDP is now projected at 2.9% and that is well below the initial expectations of 4.3% according to the Atlanta Fed real time GDPNow forecast. Since we are almost out of Q2, I would expect that forecast to settle somewhere in the 2.5% range based on the recent economic reports.


However, Citigroup's Economic Surprise Index has fallen to -80 and the lowest level since August 2011. This index tracks the various economic reports based on whether they are rising or falling and missing forecasts. We have been nearly this low in 2012 and 2015 and the world did not end. However, the sharpness of the decline suggests there are problems that need to be considered in an investment context.


On the flip side, the Dollar has recovered somewhat over the last couple weeks, although Friday was a bad day. Analysts believe once the dollar begins to rise it shows faith in the future economy.


Unfortunately, the bond investors are not convinced conditions are going to improve. The yield on the ten-year treasury closed at 2.144% on Friday and a 7-month low. This is helping the mortgage market and taking some of the sting out of rising home prices but it is a cloud over economic expectations. Bond investors typically get the economic direction right the majority of the time and they are expecting it to worsen.

I believe the bond buying has a lot more to do with the escalating events in Syria with Russia targeting coalition aircraft, North Korea and their nuclear ambitions and the potential for President Trump to do something rash and the rising tide of terror attacks internationally. Just my two cents.


The market does not seem to care about any of those problems with the Volatility Index holding at 24-year lows. Historically the VIX trades over 20 several times a year. The index has not been anywhere near 20 since the week before the election when traders were going crazy trying to forecast the outcome. The index closed at 9.75 on June 2nd. That is the lowest level since the 9.31 close on December 22nd, 1993. When you consider all the political, economic and geopolitical events over the last few weeks, to have the volatility this low is amazing.


There is nothing on the economic calendar for next week that is expected to increase that volatility. The Richmond Fed Manufacturing Survey, The Chicago Fed Activity Index and the Chicago PMI are the three most important reports. Since this is the last revision for the GDP, it will be ignored unless there is a major miss of expectations.

The economic calendar should not provide any roadblocks to successful end of quarter window dressing gains.


The earnings calendar is just as anemic for market moving events. Nike is a Dow component and their earnings after the bell on Thursday are not likely to move the market because they are only a $54 stock. It would take a 10% move in the stock to move the Dow 30 points.

We are only about three weeks away from the start of the Q2 earnings cycle and that is going to be important for market direction the rest of the year.


Late Friday, Reuters reported that Walmart (WMT) was not considering making a bid for Whole Foods Market (WFM). There had been speculation that Walmart would make a higher bid to keep Amazon out of the grocery business a little longer. Whole Foods customers are not Walmart customers and the high WFM grocery prices are not a threat for Walmart. Amazon has said they plan to lower prices because of their stronger buying power but it remains to be seen if they can do that with the niche vendors that supply Whole Foods.

Amazon is paying $42 a share for Whole Foods and the stock had run up to $43.84 in expectations for a bidding war or at least a competing offer. After the news broke, the shares declined to $42.95 and will probably bleed further next week. Kroger (KR) has also been a rumored bidder but they cannot afford Whole Foods. Kroger's market cap is $21 billion and to outbid Amazon, even if that was possible, would take a bid of $15 billion or more. I did an analysis of this back last fall when rumors were floating about Whole Foods and Kroger simply has too much debt and not enough credit. They may want to buy Whole Foods but it would be a very aggressive move in a market where gross margins are already paper thin. Kroger's market cap took a 30% haircut last week on earnings and the Amazon announcement.

Kroger has bigger problems with Aldi and Lidl moving into the USA. Lidl has more than 10,000 stores in Europe and expects to have several thousand in the U.S. in the coming years. Aldi also has more than 10,000 stores in 18 countries including 2,018 in the U.S. and those are expected to rise to 2,200 by the end of 2017. Both are major discounters and will cause serious pain to Kroger and Walmart. Aldi and Lidl are much bigger threats to their grocery business than Amazon and Whole Foods.

Unless a private equity firm steps up to start a bidding war with Amazon, the Whole Foods acquisition is likely to occur. There is the very remote chance Aldi or Lidl could make a bid but they focus on the discount shopper not the high dollar, organic shopper so the store model is not really a fit.



Some of the stocks being demoted from the Russell 1000 to the Russell 2000 include JCP, DDS, GRPN, YELP, FIT, DO, NE and ESV. Sometimes the demoted companies see shares rally after the rebalance. With the dividing line between the Russell 1000 and 2000 a market cap of about $2.0 billion, the demoted stocks suddenly become big fish in a pond of small fish. More fund managers are tracking the Russell 2000 than the 1000 and that means they will have to buy a larger number of shares of the new entrants because of their top end market cap. Of that group above GRPN, YELP and ESV have the largest market cap at $2 billion. The rest have already been crushed down to $1 billion. That makes those three stocks the most likely to see extended buying next week.

The end of quarter window dressing means portfolio managers will be adding the FAANG stocks as well as outstanding Dow performers like Boeing, McDonalds, 3M, etc. I was flipping through the charts of the Dow components and saw that Home Depot, at a new high just four days ago, was getting crushed on no news. This is somewhat confusing since existing home sales are up so strongly. The CEO was on CNBC last week and he said strong home sales and rising home prices were a boon for Home Depot. People are either improving their homes so they can sell them or remodeling because it is too expensive to move. Either way it benefits HD. Shares imploded on Friday with a $4 drop and there was no news. They hit a new high with the Dow on Monday at $159 and closed Friday at $151. Ideally, you would want to buy a rebound from $146 but at this level, they are already interesting.


Boeing (BA) should be a favorite of the window dressing crowd. We exited a nice position in Boeing on Wednesday because we were up strongly and the Paris Air Show was coming to an end. Shares typically decline after the show but apparently investors did not get the memo on the prior history and shares rocketed off to another $2.79 gain on Friday. That is going to attract window dressers like flies to a picnic.


We also exited a position on Dow component McDonalds (MCD) the prior week because we were highly profitable and the stock was due for a pullback. That dip with the market was very temporary and the stock is making new highs again. This should also be a window dressing favorite.


While we know portfolio managers are going to make sure they have some of those stocks in their portfolio by next Friday, we also know that gains like those will not continue forever. This is the fuel for a summer correction. Any fund manager that has had those stocks in their portfolio since January or earlier, has an obscene amount of profit at risk. They cannot afford to just let it ride because the next flash crash could eliminate it very quickly.

While I am positive on the market for next week, I would be cautious on the market once we are into the new quarter. The Q2 earnings cycle is likely to keep investors involved for several more weeks but August and September are the worst two months of the year. With the market at new highs, it will take very strong earnings to keep it moving forward. Expectations are very high.

Sears (SHLD) announced with a SEC filing they are closing another 18 Sears stores and 2 Kmart stores. The leases are held by Seritage (SRG), a REIT spun off by Sears a couple years ago. Sears can terminate the leases with the payment of one year's rent. In theory, that gives Seritage time to remodel and remarket the stores using the termination payment. Sears has previously announced the closing of 62 Sears stores and 164 Kmart stores this year. This brings the total to 246 locations announced in 2017. Since there have only been about 180 days in 2017 that equates to about 1.4 store closings a day. In Q1, revenue declined from $5.4 billion to $4.3 billion and they are on track to burn about $1.5 billion in cash for 2017.



Bed, Bath and Beyond (BBBY) reported earnings of 58 cents that missed estimates for 66 cents. They reported 80 cents in the year ago quarter. Revenue of $2.74 billion missed estimates for $2.79 billion. The company said they had to resort to active promotions, discounts and higher advertising costs to offset the sharp decline in customer traffic. To put their dilemma into one word, they were "Amazoned." Shares fell -12%.


Blackberry (BBRY) reported earnings of 2 cents and analysts were expecting a breakeven. Revenue of $244 million missed estimates for $264 million. Organic revenue growth in software sales rose 12% but that was slightly lower than expected. Their guidance for the year is for 10% to 15% revenue growth. CEO Chen said a lot of their products are new and are just now gaining traction. Also, most of their products are long-term sales and managing those on a quarter-to-quarter basis is a tough job. For instance, if they sell an automaker on using the QNX operating system in one of their models, it could take 12-24 months before those models begin hitting the streets but eventually there could be several hundred thousand on the road. Multiply that by the dozens of models already running the software and dozens expected to use it and they are on the right path to profitability.


Caterpillar (CAT) was downgraded from buy to hold by Deutsche Bank saying there is no way to tell if there will ever be an infrastructure plan enacted by President Trump. "Without an infrastructure stimulus we see little prospects for continued North American non residential construction growth." CAT shares declined at the open but rebounded to close fractionally positive.


We actually saw some gains in the energy sector on Friday. Oil prices were only marginally higher but energy stocks were catching a bid. This could have been sector rotation, short covering or a bet that oil prices have bottomed. I would not take that bet. I hope I am wrong but I think it is going to take a price in the high $30s to get OPEC's attention again.

There was a headline on Thursday about the potential for deeper cuts by OPEC and almost immediately three OPEC ministers said absolutely not and the existing cuts were not likely to be extended. I am surprised oil prices did not hit $40 instantly.

Personally, I believe they are going to shift into a shale starvation posture. They were unsuccessful in raising prices with their cuts and the U.S. shale production continues to shoot higher. Under $45, many shale drillers are not profitable. Around $40 they can no longer hedge their production by selling into the futures market and that means they will quickly run out of cash if they do not halt drilling. There are a few companies that can make money at $40 and those include PXD, EOG and PE to name a few. Others are going to dry up and blow away if oil stays in the $40 range. We have already seen the sudden flurry of headlines about the potential for loan defaults later this year if prices remain this low.

OPEC ministers may be changing to the long game and hoping a lot of shale drillers give up. Most OPEC countries have costs under $40 but it is still painful. Russia could be hurt the worst and that cash shortfall would curtail their ability to wage proxy wars in Syria and elsewhere. It would also hurt Iran and that would be fine with the rest of the OPEC producers.

We could be moving into a new chapter in the OPEC price war. It will be interesting to see how it plays out. Meanwhile U.S. drivers are benefitting from the lowest gasoline prices in years for the July 4th holiday. Gasoline prices in the Denver area this weekend are $2.15 at the discount stations and $2.24 on average with the cheapest at $2.06 according to GasBuddy.com. According to AAA this holiday will be the cheapest gasoline in 12 years.


Producers activated another 11 oil rigs last week and that was a record 23 consecutive weeks of gains. Gas rigs declined by 3. It should not take but 2-3 weeks for the low oil prices to begin impacting the rig activations. Once we see a negative week, it could provide a boost to oil prices.



 

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Markets

The Dow and S&P made only minor gains for the week despite the big short squeeze rally on Monday to new highs. The broader indexes pulled back daily to retrace almost all their gains by Friday's close. The Dow was up 144 points on Monday but gained only 10 points for the week. The S&P managed to add only 5 points for the week. The Nasdaq was the star performer with a 113 point gain.

The biotech sector helped to keep the S&P in the green and powered the Nasdaq back over resistance. The Biotech Index ($BTK) gained 325 points for the week. The index broke over 4,000 for the first time since September 2015.


The Nasdaq broke through the resistance at 6,245 and could be targeting the early June high close of 6,305.80. If the portfolio managers window dress with the FAANG stocks I would be surprised if we did not test that level.




The S&P spiked to close at 2,453.46 on Monday and a new high just barely over the round number resistance at 2,450. The retreat on Tuesday was sharp with a drop back to 2,436 on Wednesday it filled the gap from Monday at 2,422 and then held at 2,435 the rest of the week. Resistance remains 2,440 and was tested the last three days. Short-term support has appeared at 2,430 with longer-term support still at 2,420.

The 2,450 level could be a challenge to cross without a catalyst. That is the year-end S&P target for a number of analysts so it becomes a natural selling point. However, should a catalyst appear that causes a surge through that level we could see significant short covering.


The Dow also filled the gap from Monday's short squeeze open and then held at that gap fill level at 21,384 the rest of the week. The index overcame weakness in Goldman Sachs and Home Depot thanks to strength in Boeing, Visa, Microsoft and 3M. Even Chevron and Exxon overcame early week declines to post gains on Friday.

As I wrote earlier, portfolio managers should be buying many of the recent Dow leaders as we go into quarter end. Assuming no unexpected headlines, the Dow could be positive the first three days of the week.



The Russell 2000 surprised with a 10-point gain despite the rebalance. Since there will be some added buying to adjust positions over the next three days, this could mean the Russell will remain positive early in the week. Fund managers put in their buy/sell orders to rebalance on Friday but depending on fills, ratios and weightings, they may need to add a few shares here and there to complete the rebalance. This is a 2,000 stock index so there is a lot of fine-tuning to be accomplished.


I am expecting the first three days of next week to be positive. Where that puts the indexes will determine how the rest of the week plays out. If the S&P is bumping up against 2,450 and the other indexes against their highs, we could see a stall ahead of the holiday. Investors and managers may not want to put extra money to work until after the 4th. Monday the 3rd, the market will be a ghost town so it might as well have been a holiday. For all practical purposes it will be a four-day holiday weekend.


Random Thoughts


Sentiment was flat for the week. With the market spiking to new highs on Monday and then giving it all back by the survey's close on Wednesday everyone was neutral. This is the least change I can remember in a very long time. Just over 67% of investors still do not believe the market is going higher. On a contrarian basis that is good because those unbelievers will be chasing prices if we do move to new highs.



You may have noticed that except for two weeks in February, the markets stagnated in the first quarter. There is a good reason for that. The S&P reported last week that corporate stock repurchases totaled $133.1 billion for Q1. That sounds like a lot of money but it was 1.6% lower than Q4 and 17.5% below the $161.4 billion in Q1-2016. For the 12 months ending on March 31st, buybacks were $508.1 billion, down 13.8% from the $489.4 billion in the prior 12-month period. However, that period that ended on March 21st, 2016 was an all time record high.

Companies buy back shares to return money to shareholders in a onetime event rather than committing to a continuing dividend program. They also buy back shares to increase earnings per share. IBM has been the poster child for this for more than a decade. With earnings struggling, they would buy back shares to increase the earnings per share. It was a perfect example of financial engineering.

255 S&P-500 companies reduced their outstanding shares in Q1, down from 284 companies in Q1-2016. The top 20 stocks accounted for 42.1% of all share repurchases.

Another reason for slowing buybacks is high stock prices. With the market at its highs, companies do not want to buy their own shares. They would rather wait for a dip to get more bang for their buck.

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The Supreme Court has only one week left before their summer recess. They are expected to rule on the administrations travel ban but the news everyone is expecting would be a retirement announcement by Justice Kennedy. He turns 81 next month and while nothing has been said, there have been clues that he could announce this week that he is retiring. He has been a justice for nearly 30 years. This could start another firestorm of headlines in Washington and further divide the parties in the Senate.


 

Enter passively and exit aggressively!

Jim Brown

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"Experience is the hardest kind of teacher, it gives you the test first and the lesson afterward."

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