The markets continued to languish in a holding pattern as we await the FOMC meeting next week. Were it not for the big energy mergers announced before the bell there would have been nothing for the markets to focus on for Friday. The equity market indexes remain stuck in the neutral zone ahead of the Fed but bonds continued their eight-day bull run. Economic reports released on Friday continued to show a slowing economy creating even more uncertainty about the coming Fed decision.
The only economic report on Friday was Durable Goods for May which fell more than expected by -0.3%. This followed a much more severe -4.7% decline in April. New orders ex-transportation rose +0.7%. Back orders rose +0.6% and inventories rose +0.4%. Orders for individual sectors showed gains in machinery of +2.3%, computers +1.9% and communications equipment of +5.9%. The highly volatile civilian aircraft sector saw a -17.9% drop. That is totally dependent on order flow at Boeing and that can fluctuate by several billion dollars per month and should be ignored in reference to the other sectors. The drop in aircraft orders was solely responsible for the drop in the headline number. The rise in back orders was the 6th consecutive monthly gain and back orders are up +20% from a year ago.
The +0.7% rise durable goods orders ex-transportation showed more economic strength that the reports we saw earlier this week. The CFNAI on Thursday fell to -0.16 and the lowest level since the hurricane drop in Q4. Weak job gains and rising jobless claims also suggest a weakening economy. The Leading Indicators released on Thursday fell -0.6% for May with only three of the ten components showing gains for the month. The six-month annualized growth rate dropped to -0.4% and the first negative number since June 2001. Industrial production for May also fell -0.1% when a +0.2% gain was expected. The Fed will consider all these factors when it meets next week. The bond market has been very strong for the last two weeks with yields on the ten-year rising to 5.22% from 4.95%. The near vertical rise is due to the weakening economic indicators and the growing potential for a 50-point hike.
Ten-Year Note Yield Chart - 30 min
For the first time in recent memory there is significant disagreement as to what the Fed might do. Yes, I know there is always the hike/no hike question but this time it is worse. There is a growing number of analysts expecting a possible 50 point hike. But, due to slowing economic factors there is also a growing contingent who feel the Fed could surprise everyone with a pass. Remember, Bernanke did say that the Fed could take a pass even if the data warranted a hike. The Fed itself said in the minutes from the last meeting that they did not know if they should hike 50 or pass. If the Fed thinks the economy is slowing and on track to reduce inflation by itself then they could pause to watch another month of data. However, the majority of analysts expect another 25-point hike followed by another 25 points on August 8th. This sets up mass confusion in the markets because nobody knows which way to place their bet with three potential outcomes. There was an economic study a while back that showed inflation normally peaked 6-9 months after the economy peaked. Since we have pretty good indications that the economy peaked in the first quarter that targets an inflation peak later this year. This should not be lost on the Fed since one of the authors of this study was Bernanke.
The CEO of Liquidnet, a large block institutional trader for institutions and hedge funds, said activity had slowed to a crawl with nobody making any big bets. This is borne out by the tight range and lower volume we saw in the markets this week. He said fund were sitting on huge amounts of cash and were showing no interest in placing bets ahead of the Fed decision. He also said the funds were waiting for a market direction to appear. Many funds were cautious and expecting another leg down in the market. With major corrections seen as a -20% drop they feel we are only half way. The CEO said most funds had lost their gains for the year in the May crash and that made them less inclined to take a risk that could put them into a losing position for the year as summer volatility progresses. Most were not even planning on window dressing for the end of quarter due to the convergence of events clouding next weeks forecast. He said many hedge funds had June-30th redemption periods, which required higher cash levels for withdrawals. This interview was an insightful look into what is really happening in the fund mindset. The average Liquidnet trade is more than 50,000 shares worth more than $1.15 million. Most of their trades are matched with other buy side institutions and never make it to the exchanges. This prevents impact to prices since other market participants never see the trade. There are currently about 9000 hedge funds, 2000 new ones opened in the last year, managing $1.6 trillion in assets. Can you imagine if all those funds were trading directly into the market without the benefit of the large block middlemen? We know that more than 70% of current market volume is from program trades and more than 30% is fund related and that is in addition to party-to-party trades by companies like Liquidnet.
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The big news of the day was not the economic reports but the acquisitions in the energy sector. Headlining the news was the $16.4B acquisition of Kerr McGee (KMG) by Anadarko Petroleum. That was not enough for APC, which also announced the $4.7B acquisition of Western Gas Resources (WGR). The KMG buyout represented a +40% premium to Thursday's closing price. The WGR acquisition represented a +50% premium. In a smaller deal Energy Partners (EPL) won the battle to acquire Stone Energy (SGY) for $1.4B beating a competing bid by Plains Exploration (PXP). The Anadarko acquisitions sent both KMG and WGR soaring with each posting better than an $18 gain for the day.
The big question throwing the energy sector into turmoil was why did Anadarko pay such a big premium? Street analysts were scratching their heads wondering why recent acquisitions were valuing companies so much higher than the current street prices. It is very simple if you think about it. The people running these big exploration and production companies KNOW without a shadow of a doubt how hard it is to continue growing reserves. There has not been a major new find since the early 1980s. Every day that passes sees another field go into permanent decline. Every new discovery is harder to find and harder to produce with a lower payout despite higher prices. The politicians (EIA/IEA) claim there is another trillion bbls of undiscovered oil but nobody can find it despite a thousand holes drilled each month. It is one thing to guess about potential undiscovered reserves but quite another to try and turn them into gasoline. It is a perfect example of theory confronting reality and reality always wins.
These large companies are simply finding it easier to buy reserves than find them and despite the price paid for Kerr McGee it only amounts to $12 a bbl for their proven reserves. With today's average cost of a newly discovered bbl at $28 and another $8-$12 to get it from below ground and into a pipeline these companies with existing reserves are a bargain. It is the only way for the major companies to replace their reserves and continue growing. Unfortunately it does not add to overall global reserves. It simply subtracts reserves from one balance sheet and adds them to another. For the world to benefit these companies need to actually find new oil and that is becoming harder to do every day.
Every recent acquisition including the big $36B Burlington acquisition by Conoco @ $18 bbl was criticized as buyers paying too much. With oil holding at $70 a bbl those acquisition costs look like a bargain. Energy analyst Bruno Stanziale with Societe General said it was a great deal for APC given his $85 target for crude before the year is out. APC said it planned to hedge 75% of the acquired production through 2008 using three-way collars that provided a substantial return on investment at the floor price while allowing for significant upside if prices continued to move higher. APC also said it would sell off non-core assets of the combined companies to further reduce any debt incurred in the acquisition.
APC expects to produce 705 mboe from the Western acquisition at a recovered cost of less than $10 boe. They expect to produce 3.1 billion boe from the Kerr McGee deal at a total cost of $12.40 per boe. BOE means barrel of oil equivalent. Since a large portion of these reserves are natural gas the BOE descriptor normalizes the value to a cost per barrel. Roughly 6000 cubic feet of gas equates to one barrel of oil. For me it was a deal made in heaven. You acquire $10 billion in 2005 annual sales, probably $12 billion in 2006, hedge 75% of it at $70 a bbl through 2008 with an acquisition cost of $12. Sell off the non-core assets for several more billion and end up with 3.2 billion bbls of reserves you did not have before worth $192 billion at $60 a bbl. How many companies would love to buy $192 billion in known assets for $21 billion and pay for the majority of the cost by hedging future production through 2008? Add in the undiscovered assets from their current leases and the deal gets even sweeter. Everybody is a winner!
The sudden realization that energy company evaluations were well below current stock prices sent investors scrambling for bargains. Big winners were UPL, $8B market cap, +5.82 and EOG, $15B market cap, +3.92, both strong gas producers. The race was on by analysts to predict the next acquisition targets. Since Kerr McGee was $16.4B everyone under $20 billion came under scrutiny. The names making most of the target lists are listed in the table below. Even Devon Energy with a market cap of $24.5 billion was rumored to be a potential target. If the majors, Chevron at $130B market cap or Conoco at $108B decided the pool of dance partners was shrinking Devon would be a likely target given the majors favor larger scale enterprises. For a major to buy a company as small as Cabot for $2B it would hardly be worth the effort. Buying a small company would be worth the effort for somebody like EOG or DVN who might want to start bulking up to move themselves higher up the food chain.
Potential takeover targets
Oil prices held firm at just under $71 as speculators used the acquisitions as confirmation that the industry expected prices to move higher over the long term. A tropical depression is said to be forming east of the Bahamas but is not expected to develop into anything that would threaten the oil fields. The gulf picked up another +3% of production that had been shut in since Katrina leaving only 9% still offline. I am surprised oil prices are holding at this level with gasoline supplies 600,000 bbls above the five-year average. Add in 1.8mb of ethanol to be blended just before delivery and that jumps to 2.4mb above the five-year average. Crude oil inventory levels are 35mb or +11% above that average. The prices are holding because of Nigeria, Iran and fear of another strong hurricane season. Eventually the prices will begin to slide towards an August low if no hurricanes develop in the Gulf and Iran does not heat up. I expect that slide to begin after July 4th.
The energy acquisitions did not help everyone with major warnings coming from Six Flags and City National. Six Flags (SIX) lost -25% of its value after warning that prior projections would not be met and it was putting six of its twenty-nine parks up for sale including its flagship Magic Mountain park in California. Analysts were quick to distance themselves from SIX after the company said it might be in violation of its bank covenants.
City National (CYN) warned that earnings per share could fall as low as +1% growth compared to expectations of +8% to +10%. The problem is slowing deposit growth as customers switch funds to higher yielding money market accounts and withdraw cash for other uses now that the home refinance ATM has run out of cash. If you remember the interest rate chart I showed on Wednesday night you will understand the rate pressure on these banks. When they have to pay more than 5% to compete with the money markets it lowers their profits since interest rates on loans have not risen as quickly. Unionbancal (UB) and Comerica (CMA) were cut to a sell by Merrill Lynch on similar rate concerns. CYN lost -$7.71, UB -3.20 and CMA -2.14. This pressured the entire financial sector although the larger banks like Citigroup and Wells Fargo have yet to feel similar pain due to their broader base and product offerings.
Build a Bear (BBW) warned that earnings would be at the low end of its prior expectations due to lower than expected sales. BBW lost -$4.49 or -17%. Tektronix (TEK) lost -2.27 or -7.5% after posting decent earnings but giving lower than expected guidance. S&P upped TEK to a buy from hold despite the lowered guidance.
The transports tacked on another +35 points on Friday thanks in part to Old Dominion Freight Lines (ODFL). ODFL said it expected earnings nearly +25% higher than prior guidance due to a +17% increase in LTL tonnage for the second quarter. ODFL gained +2.69 with the good news pushing FDX up another +1.56.
The combination of weak but level economics, fear of the Fed and a mixed earnings picture with both positive and negative warnings kept the indexes flat ahead of the weekend. There is simply too much confusion about the Fed direction and at this point about Q2 earnings for traders to feel good about buying the bounce from the prior weeks lows. The indexes all traded in a tight range for the week and ended mostly in the middle of that range.
The Dow is stuck at 11000 and can't seem to get away on the low volume. The intraday bounce did not hold and it ended with a -30 point loss. Wednesday's short squeeze bounce was completely erased but there was no credible effort to push it below 11000. It appears the buyers are content with waiting at that level for the Fed meeting to begin. Initial support remains 10930 and resistance at 11060.
Dow Chart - 30 min
Nasdaq Chart - 30 min
The Nasdaq, like the Dow, remains pinned to 2125 with initial support at 2105 and resistance at 2150. The few tech warnings we have seen were partially offset by strong earnings from Oracle and expectations about the Microsoft and Intel announcements coming on Monday. It is still early in the tech warning cycle and investors are still cautious. The SOX has also flat lined between 445-460 with chip warnings taking the excitement out of last week's bounce.
The Russell-2000 has maintained an upward bias all week with a close at 690 and appears to be giving Russell speculators a second chance ahead of next Friday's rebalance. It is going to be a tossup between possible post Fed window dressing and rebalance selling but baring a Fed surprise I am betting on a decline into Friday's close. The S&P remains trapped between 1240-1260 and without volume this is where it is likely to stay until the Fed meeting passes.
SPX Chart - 30 min
Note in the market internals above that volume declined into the weekend with Friday unable to break 4B shares. This is a far cry from the 6B-7B shares we saw over the last couple weeks. The market is trapped in a holding pattern while we wait on the Fed. The Advance/Decline line was almost perfectly flat on Friday but I did notice an increase in new lows and a decrease in new highs. This is not a good sign and suggests a negative bias to the market despite the flat range.
For next week I would advise going fishing rather than trying to trade the market. Volatility will likely increase but the range may not. This produces a very choppy market that wears down traders and extracts money from their accounts. There is a good possibility that the Fed decision is going to surprise quite a few traders. The potential for a 50-point hike or even a pass could really shake up the market. If we did get a 50-point hike I would buy any material dip. This could be seen as the last hike with the Fed going into neutral while waiting for the summer economy to pass. If we get a pass I am neutral for market direction. There would probably be an initial bounce but investors may fear the Fed is not in tune with the times and continue to worry about future hikes. It is odd but this is one time I believe the markets would rather have a 50-point hike than a pass. With that said a 25-point hike might not give the markets any consolation with the futures already pointing to something in the 5.75% to 6% range by year-end. It will be entirely up to the statement to calm the markets or give them indigestion.
I received several emails after I changed the market stats graphic last weekend. Readers asked for the symbols for the various market and sector indexes. The table above lists the ones I am using. Unfortunately all the different charting programs and quote systems will require some tinkering to get them to work. Some will not recognize the dollar sign and some will not want the X appended to the symbol. Experiment with them until you find the combination your chart program wants.
Play Editor's note: We are not adding a lot of new plays to the newsletter this weekend. If you read this weekend's market wrap then you already know that our market bias is mostly flat as we head towards the next interest rate decision on Thursday's FOMC meeting. With that in mind we would not be in a rush to open new positions ahead of the Fed's decision.
Bear Stearns - BSC - cls: 134.95 chg: -0.30 stop: 129.99
Why We Like It:
BUY CALL AUG 135.00 BSC-HG open interest=161 current ask $5.90
Picked on June xx at $ xx.xx <-- see TRIGGER
Marathon Oil - MRO - close: 76.72 chg: +1.84 stop: 73.95
Why We Like It:
BUY CALL AUG 75.00 MRO-HO open interest=433 current ask $5.40
Picked on June xx at $ xx.xx <-- see TRIGGER
Chipolte Mex Grill - CMG - cls: 61.90 chg: -0.95 stop: 57.45
CMG, like the market, churned sideways last week. Overall shares of CMG are still trading inside its bullish, rising channel (see chart) and its Point & Figure chart points to a $78 target. We're not expecting much from CMG until after the FOMC meeting this coming week so traders might want to wait until we see what direction the market is going. If you're looking for an entry point you could buy calls here near $62 but we'd prefer trying to catch a dip and bounce near the $60.00 level (probably 60.50-60.60). Our target is the $67.50-70.00 range. We do not want to hold over the late July earnings report.
Picked on June 18 at $ 61.76
Cognizant Tech. - CTSH - close: 66.56 chg: +1.75 stop: 62.49
CTSH turned in a strong week. The stock displayed plenty of relative strength on Friday with a 2.7% gain to close over potential resistance at the $65.00 level again. Friday morning's move over $65.05 was a new entry point. We did not see any specific news to account for Friday's strength but we're not going to complain about it. Our only concern would be that volume was not very impressive on Friday's gain. At this time we would probably suggest looking for a dip back toward the $65.00 area as an entry point to buy calls. Our target is the May highs in the $69.50-70.00 range. The P&F chart has a triple-top breakout buy signal with an $80 target.
Picked on June 24 at $ 65.05
General Dynamics - GD - cls: 65.40 chg: +0.08 stop: 63.99
The major market averages churned sideways last week and shares of GD followed suit. The stock has been bouncing around the $65-66 range and we're not anticipating any change from that pattern until after the FOMC meeting. Yet that doesn't mean that readers can't be ready for a potential entry point if one appears. The midday strength on Friday looked like an entry point but the rally faded. Now we would look for a move past Friday's high (66.17) or a bounce from the $64.50 region to be used as a new bullish entry point to buy calls. Our target is the $69.00-70.00 range.
Picked on June 18 at $ 66.12
Google - GOOG - close: 404.86 chg: + 4.91 stop: 384.50
GOOG displayed some relative strength on Friday with a rally to $409.75. Unfortunately, some afternoon profit taking pared its gains leaving shares with a 1.2% gain. Volume came in pretty low. One concern we have is that the markets are likely to trade sideways until after the FOMC meeting concludes next week. Without any market support then GOOG may just continue to bounce around its slowly rising, bullish channel. It's easy to see on the hourly chart. If you start the channel around May 19th you can see that GOOG has rallied toward the top of the channel and now looks vulnerable to a pull back toward the bottom of the channel near $395-392.50 (maybe $390). We would hesitate to open new bullish positions at this time but a bounce from the 50-dma near $395 (or even the $400 level) could be used as an entry point. The Point & Figure chart remains bullish and points to a $444 target. Our target is the $440-445 range.
Picked on June 21 at $401.00
Legg Mason - LM - close: 100.90 chg: +0.90 stop: 96.99
The XBD broker-dealer index is flirting with a bullish breakout from its eight-week bearish channel and resistance at the 210 level. We would be cautious about buying calls in this group until the XBD does trade over the 210 level. Meanwhile shares of LM are still churning sideways between $98.50 and $102.00. The high on Friday was $101.92. We've been suggesting that readers wait for a move over $102.00 or $102.50 as a potential entry point to buy calls. More conservative traders may want to raise their stop loss toward $98.40 under the bottom of the current range. We are somewhat concerned that LM will hit resistance at its descending 50-dma, currently at 106.62. As an alternative we're going to list a new play in this sector with a trigger to catch any future breakout.
Picked on June 18 at $102.45
Manpower - MAN - close: 64.91 change: -0.33 stop: 63.99*new*
The rally in MAN is struggling to maintain any momentum. Shares broke out on Wednesday only to reverse course. It might be just profit taking or last week may have been a bull trap. The MACD on the daily chart is bullish but the MACD on the weekly chart is bearish. We rarely do it but we need to widen our stop loss. Our stop was at $64.45 and MAN almost hit our stop loss on Friday with a low of $64.47. More conservative traders may want to leave their stop where it's at. We're going to adjust our stop loss to $63.99, which is underneath short-term support at its 10-dma (64.14). We are not suggesting new bullish plays until MAN trades back above $66.00 (or 66.50). Our target is the $69.85-70.00 range. The P&F chart now points to an $80.00 target so more aggressive traders may want to aim higher. We do not want to hold over the mid-July earnings report.
Picked on June 21 at $ 66.05
Reynolds American - RAI - cls: 110.66 chg: -0.49 stop: 107.75
We are urging a new sense of caution with RAI. Some of the momentum indicators are turning bearish. The stock has pulled back toward support near the $110 level and its 50-dma (110.25). RAI hit a low of $109.70 before bouncing on Friday. More conservative traders may want to put their stop loss under Friay's low. We're going to keep our stop under tested technical support at its rising 100-dma. However, a close under $110 would look pretty negative! We are suggesting two targets. Our conservative target is $115.00. Our aggressive target is $119.00. The P&F chart is still bullish and points to a $148 target.
Picked on June 15 at $111.15
United Tech. - UTX - close: 62.28 chg: +0.39 stop: 59.95*new*
UTX displayed some relative strength on Friday with a breakout over short-term resistance at $62.00. Unfortunately, the stock is still trading under technical resistance at its 40 and 50-dma(s). We only have about three weeks left before UTX is expected to report earnings and that's with an unconfirmed announcement date. We may have less time. Keep that in mind when considering new plays. We are going to raise our stop loss to $59.95 since UTX should have support at $60.00 and its 100-dma near 60.25. Our target remains the $64.00-65.00 range.
Picked on June 08 at $ 60.13
Apple Computer - AAPL - close: 58.83 chg: -0.75 stop: 60.05
The technical picture for AAPL is looking more bullish. The MACD, RSI and stochastics have all produced bullish buy signals in the last couple of days. Yet the stock is struggling to see any follow through higher. We are going to keep AAPL on our play list as a bearish candidate for now although we'll probably drop it if shares close over the $60.00 level. On Thursday we suggested that more nimble and aggressive traders might want to consider buying calls if AAPL can breakout past the $60 level. We're keeping our strategy to buy puts if AAPL trades at $56.85 or lower. If triggered our target will be the $50.50-50.00 range. We do not want to hold over AAPL's mid July earnings report. FYI: The Point & Figure chart points to a $44 target.
Picked on June xx at $ xx.xx <-- see TRIGGER
Amgen Inc. - AMGN - close: 64.93 chg: -0.04 stop: 67.55 *new*
AMGN tried to bounce on Friday but shares ended up producing a new lower high. We only have about three weeks left before AMGN is expected to report earnings. If you are considering new bearish positions here you may want to use a tighter stop loss and aim for the $60.00 region. We are going to lower our stop to $67.55, just above the descending 50-dma. Currently our target is the $62.65-62.25 range although the P&F chart points to a $60 target. AMGN is due to present at another conference on Tuesday this week. That always increases the risk of some sort of news event moving the stock.
Picked on June 05 at $ 67.48
Carpenter Tech. - CRS - close: 104.79 chg: +1.75 stop: 105.01
We are still in a wait-and-see mode with CRS. The stock, like most of the market, churned sideways last week. CRS' range was between $100 and $105.50. Some of the technical indicators on the daily chart are suggesting the next move may be higher. If that is the case then aggressive traders might want to consider buying calls on a move past $107.50 or $110 although we would expect some resistance at the 50-dma near $115 and then more resistance near $120. Currently the P&F chart is still bearish and points to a $76 target. Since we don't have a bullish market outlook we're going to keep CRS on the list as a put candidate with a trigger to buy puts at $99.25.
Picked on June xx at $ xx.xx <-- see TRIGGER
Digital River - DRIV - cls: 40.56 change: -0.85 stop: 42.05
This looks like a new entry point to buy puts on DRIV. The stock produced another failed rally under the $42.00 level on Friday. Volume came in below average. We would probably wait for a move under the 10-dma and the $40.00 level before actually initiating new put plays here. Our target is the $35.25-35.00 range. The Point & Figure chart points to a $26 target.
BUY PUT JUL 40.00 DQI-SH open interest=2462 current ask $1.50
BUY PUT AUG 40.00 DQI-TH open interest=1292 current ask $2.55
Picked on June 19 at $ 39.45
Express Scripts - ESRX - cls: 67.27 chg: +1.47 stop: 70.10
ESRX is another stock that has consolidated sideways over the past week. It's worth noting that since shares were already a little oversold the sideways trading is pulling the technical indicators toward new bullish signals. Overall we remain bearish as long as ESRX remains under broken support, new resistance at the $70.00 level. Our conservative target at $65.25 was hit days ago and now we're aiming for the $60.50 mark. The Point & Figure chart points to a $52 target.
Picked on June 08 at $ 69.59
Group 1 Auto - GPI - close: 54.26 chg: +0.99 stop: 58.46
We are not suggesting new plays with GPI. Instead for the last few sessions we've been suggesting that traders lock in profits before the stock produces an oversold bounce. It looks like that oversold bounce may have begun on Friday. Shares of GPI added 1.85% but the bounce did struggle wit resistance near $55.00. If you're not willing to endure a rebound to potential resistance in the $57.00-58.00 region then consider exiting now for a gain. Our target is the $51.50-50.00 range.
Picked on June 11 at $ 58.46
Intl. Bus. Mach. - IBM - cls: 77.10 chg: -0.09 stop: 80.05
IBM continues to flirt with a breakdown under support in the $76.75-77.00 range. As long as the stock continues to trade under its current six-week trendline of lower highs we're going to remain bearish. Our target is the $73.50-73.00 range. Please note that we will be running into a time crunch soon. We don't want to hold over the mid-July earnings report expected in about three weeks.
Picked on June 06 at $ 78.75
IDEXX Labs - IDXX - close: 75.12 chg: +0.98 stop: 78.05
Friday saw IDXX produce an oversold bounce following Thursday's breakdown. The stock has reclaimed the $75 level and its 200-dma(s). We would expect the bounce to hit its 10-dma near $76 before failing. Our conservative target at $75.25 has already been hit. Now we're aiming for the $72.00 level.
Picked on June 12 at $ 77.95
Oshkosh Truck - OSK - close: 49.15 chg: +0.30 stop: 51.51
OSK is another stock that spent last week consolidating sideways with the major averages. However, what makes OSK different is that the consolidation had a bearish tone to it with a failed rally near $50 and its 200-dma. We remain bearish but traders looking for new positions might want to wait for a drop under $48.00 before initiating plays. Our target is the $45.50-45.00 range. The P&F chart points to a $34 target. In the news OSK announced it would purchase AK Specialty Vehicles for $140 million from HealthTronics (HTRN).
Picked on June 13 at $ 49.49
Intuitive Surgical - ISRG - cls: 107.51 chg: +2.89 stop: 108.25
We have been stopped out of ISRG at $108.25. We warned readers that this was an aggressive plays and that shares were volatile. It looks like the recent breakdown under its 200-dma and the $100 level was nothing but a bear trap (and a bounce from its P&F chart support). The weekly chart now has a bullish-reversal candlestick. Traders might want to switch directions and buy calls if ISRG can trade over $110 or its 50-dma near $113.00.
Picked on June 19 at $102.45
Supertex - SUPX - close: 36.62 change: +0.25 stop: 37.05
The SOX semiconductor index is still stuck inside its seven-week bearish channel. Meanwhile shares of SUPX are still consolidating between $35.00 and its 200-dma near $37.00. Unfortunately, the intraday rally on Friday in SUPX hit $37.19 and the night before we had lowered our stop loss to $37.05 to reduce our risk. The stock continues to look bearish. We would still consider put positions here or on a breakdown below the $35.00 level.
Picked on June 19 at $ 35.99
"The Fed fund futures predict an eighty percent chance of a quarter-point rate hike at the hike at the next FOMC meeting," someone on CNBC intones. How is that calculation made?
The calculation utilizes the thirty-day Fed funds futures. The CBOT introduced its Fed funds futures in late 1988. Fed fund futures are listed for the current month and the 24 succeeding months. QCharts employs FF as the symbol for these futures, and then appropriate symbology for the year and futures-expiration month would also be used. Therefore, on QCharts, the June 2006 Fed fund futures would be FF06M.
This June contract expires the last business day of the delivery month, on June 30, with trading closing at 2:00, Chicago time. On the CBOT site (www.cbot.com), a sidebar on the right-hand side allows you to follow a link to the thirty-day Fed fund futures and find more information such as tick size, price quote, settlement and trading hours. However, be aware that these futures are subject to volatile moves in jittery markets, especially times when any FOMC member might be slated to speak. This article isn't meant to encourage you to trade them, but rather to understand all those predictions you hear.
The futures are associated or aligned with the FOMC's targeted rate, but market forces also impact them. Other sites offer information on how the Fed uses its open market operations to supply the reserves that keep the Fed funds aligned with the targeted rate, but that's not the purpose of this article, either. We're interested in how the futures are used to make that prediction. On June 12, when this article was originally prepared, the June Fed fund futures closed at 94.9650. To calculate the suggested interest rate at the delivery of that contract at the end of June, the Fed funds futures value would be subtracted from 100, resulting in a suggested rate of 5.035 (100 - 94.9650).
On the same date, the July Fed fund futures closed at 94.79, resulting in a suggested rate of 5.21 at July expiration on the last business day of July. That's a spread of 0.175 or 17.5 basis points between the June and July contracts, as of June 12 at least. According to the CBOT site, it's normal to see a spread of 4-8 basis points (or 0.04-0.08) from one month's contract to the next. If the spread in one month's Fed futures rate and the next month's is less than 9 basis points (or 0.09), the market is not anticipating a change in the Fed's policy. If that spread widens to a range of 12-15 basis points, the market does anticipate that the FOMC will change its target rate. Clearly, on June 12, markets were anticipating a hike in interest rates, but we all knew that, didn't we?
How much of a hike were the futures predicting, and what was the probability assigned to that hike? First, it's important to know that there is no July FOMC meeting. Checking http://www.federalreserve.gov/fomc/#calendars for a schedule of meetings turns up that information. That means that those July futures must have been pricing in a chance that the FOMC will raise rates in late June since they were predicting a higher interest rate by the expiration of those July futures. Since the Fed changes rates in increments of 0.25 or 25 basis points, those futures were pricing in a chance of a 0.25 hike in rates, not a 0.21 hike.
How can we determine the probability of that hike? Dividing 0.21, the spread between the current Fed funds target rate set by the FOMC and the future rate predicted by the July contract, sets that probability. Making that calculation determined that on June 12, the market considered the likelihood that the FOMC will raise rates by 0.25 or 25 basis points to be 0.84 or 84 percent. John B. Carlson, William R. Melick, and Erkin Y. Sahinoz, writing "An Option for Anticipating Fed Action," (http://clevelandfed.org/research/Com2003/0901.pdf) also suggested using futures other than front-month ones (June, in this case) to make predictions of the Fed funds target rate and suggested a further out futures contract, one two months out.
If the consensus on June 12 was that the FOMC would either pause or raise by a quarter basis point, as it seemed to have been at the time, then the probability that the FOMC will pause would be 16 percent (100 percent minus the 84 percent the market has assigned to the probability that a 25 basis-point hike will occur). If the consensus is that the FOMC will either raise 25 basis points or 50 basis points, then that 50-basis-point hike is also assigned a 16 percent probability.
What if there had been no market consensus on June 12, and some had believed that there would be a pause; some, a 25-basis-point hike and others, a 50-basis-point hike? Those would have formed three possibilities to be divided among a 100 percent probability.
Then it becomes more difficult to make those predictions. Some experts suggest that even when only two possibilities are suggested, it's perhaps simplistic to use the Fed funds futures in the manner described above to predict the possibility of a certain hike. If those futures were to suggest a 30 percent chance of a hike, for example, do you know whether most were pricing in only a 20 percent chance of a hike, but then a few went out to a 80 percent chance, so that the average would work out to 30 percent although fewer futures buyers believed in a hike?
Since the introduction of options on the Fed funds, many have begun suggesting that options might be better used to make these predictions. Those options allow for an examination of how the spread in prices across several strikes differs from the actual differences in prices. For example, if there's a relatively big difference in the prices of a lower-strike call option and a higher-strike one when compared to actual difference in the strikes, options buyers are betting that the Fed funds futures will settle above the lower-priced call but below the lower-priced one, some suggest. If the spread in prices for the two call strikes is near the difference in the two strikes, they're betting that the Fed fund futures will settle above both. The use of options does not restrict calculations to two possible outcomes since several strike pairs could be examined. A bell-curve of probabilities can be obtained.
Others suggest another problem with using the simple calculation explained above to predict the Fed funds target rate the FOMC will set at the next meeting. In "How Well Does the Federal Funds Futures Rate Predict the Future Federal Funds Rate?" (http://clevelandfed.org/research/Com2003/0901.pdf), Ed Nosal sets forth a conclusion that Fed funds futures rates may overestimate the future target Fed funds rate when those rates are falling and underestimate the future target Fed funds rate when rates are rising. Nosal moved four months out from the current month to remove bias, further than Carlson, Melick and Sahinoz's two months to accomplish the same purpose.
Despite the potential problems with using the Fed funds futures to predict FOMC moves, it's helpful to see what those futures suggest and understand all those probabilities being discussed. Want to know more or read it described in different words? Check out the Federal Reserve Bank of Cleveland's site at http://www.clevelandfed.org/research/policy/fedfunds/faq.cfm for more details and examples of how these calculations are made. Then you, too, will know what the Fed fund futures predict.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.
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